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Re-Ranking the Forbes 'Best Small Caps' List

NEW YORK (TheStreet) -- Study after study has confirmed that small caps outperform large caps as a group over the long run. Some good small-cap ideas we'll look at below include Pre-Paid Legal Services (PPD), Sturm, Ruger (RGR), Deckers Outdoor (DECK), Darling International (DAR) and Quidel (QDEL).

There are many arguments to support owning small caps in your portfolio. Yet, investment banks, money managers, TV pundits, and research firms generally ignore them.

The inclusion of small-cap stocks is one of the main reasons Joel Greenblatt's Magic Formula Investing keeps outperforming the market. The hedge-fund investor's strategy works fine for stocks with more than $1 billion market caps, returning 20% annually between 1988-2004 (as shown in The Little Book that Beats the Market). But when you expand the universe of stocks to include those with a market cap of $50 million or more, the performance vastly improves, returning nearly 31% annually over the same period!

Perhaps the most intriguing list of small-cap companies is produced every fall by Forbes, in its Best Small Companies List. This year, Forbes editors picked 100 publicly traded companies with sales under $1 billion and a stock price above $5, filtering out firms with accounting and/or legal troubles. Then it ranked those stocks based on an unspecified recipe including earnings growth, sales growth and returns on equity. The result is a universe of what I found to be very intriguing small-cap companies.

I thought it would be interesting to apply the Magic Formula ranking system of earnings yield and return on adjusted capital to see which of these firms best met the "great companies at cheap prices" goal of MFI. Below are the rankings.

One Forbes stock, Portfolio Recovery Associates (PRAA), has an asset-based business model (like a bank or insurance company) and was excluded. Entries with an asterisk currently appear in the official MFI screens. The statistics below were calculated using the MFI stats calculator tool.

Ranking the Forbes Best Small Companies List

So, where can we go to find good small-cap ideas? MFI is certainly one place. Here is our analysis on Pre-Paid Legal Services, Sturm, Ruger, Deckers Outdoor, Darling International and Quidel.

Steve Alexander is the founder and editor of MagicDiligence.com, a site that analyzes stocks appearing in hedge-fund investor Joel Greenblatt's Magic Formula Investing screens. Alexander is a private investor with more than a decade experience in the market.

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