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Deal Or No Deal: 8 Undervalued Small Cap Stocks

James Dennin, Kapitall: We screened for undervalued small cap stocks by looking at price of sales and return on equity.

The stock market performed well yesterday, building on its four day rally. Retail numbers took a dip, which is disconcerting because it suggests Americans are spending less. However, these numbers were offset by news of the Comcast (CSCSA) Time Warner (TWC) merger and a generally robust earnings season.

Read more from Kapitall: The Olympics: Big Business from Start to Finish?

Of the companies that have reported earnings so far, more than 70% have exceeded analyst expectations. This means that analysts were either overly pessimistic in their projections, or the economy is gaining momentum. 

That's the perspective being offered by the Fed. Though the market enjoyed a bull run last year, the days when former Reserve Chair Ben Bernanke talked about tapering caused the stock market to sell off. Investors thought good news would presage the end of the Fed's asset purchasing program that supported (if not inflated) high nominal stock prices.

When Reserve chair Janet Yellen said in her first public comments that she's seeing improvements in many areas of the labor market, the stock market rallied. This is particularly significant because it means the market may have finally absorbed the inevitability of tapering into prices. In addition, the market may believe Yellen will be more dovish on inflation than her predecessors.

Investing Ideas

Small cap stocks often perform well in both high- and low-inflation environments because they generally produce unique and niche items with high price elasticity. With this in mind, we decided to build a list of undervalued small cap stocks  with a high return on equity (ROE) and low valuations based on price-to-sales (P/S) .

The Price to Sales ratio looks at the amount a company spends generating each dollar of sales. A low ratio indicates that the company is operating efficiently, generating lots of revenue on fewer resources.  ROE is another measure of efficiency and looks at the return a company generates on each dollar of equity it raises from investors. Stocks with very high ROE usually trade at a premium, so when they are also undervalued it is often an indication that the stock is worth investigating further.

After narrowing a universe of US equities to a P/S ratio below .1 and an ROE above 15% we were left with 8 stocks on our list. 

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