In the early stages of an economic recovery, the stocks of small companies outperform the shares of the big guys.

Take a look at the 3,000 U.S. stocks tracked by the Frank Russell Co. for its indices.

  • So far in 2003, the Russell 1000 stock index, which tracks the performance of the stocks of the largest 1,000 companies, is up 17%.
  • The Russell 2000, which tracks the performance of the smallest 2,000 stocks, is up 32% for the year to date. (The stocks in the Russell 2000 account for about 8% of total market capitalization of the Russell 3000.)
  • Often, as an economic recovery advances, big-company stocks begin making up the difference. That's because these companies can use their massive advantages of scale to reap more than their share of the economic pie.

    Small Victories, Big Gains

    But in this economy, small-company stocks should keep leading the way. That's because the economy is rebounding in this recovery at a slower pace than usual, and it looks like growth will remain relatively modest even as the recovery continues.

    That will play to the leverage that's built into small-company stocks, which are far more likely to react to even modest increases in sales and earnings than big companies. The latter have to show massive increases in sales volume to produce a measurable change in their bottom lines.

    Think of it this way. General Electric ( GE) added $668 million in sales in the third quarter of 2003 from the same quarter of 2002. But that was a paltry 2% of the company's $33.4 billion in third-quarter revenue.

    On the other hand, a company like Calavo Growers ( CVGW), one of the stocks on my list of micro-cap winners, increased sales of its avocados and papayas by a comparatively tiny $4.9 million in the third quarter of its fiscal 2003 from the same period in 2002. But that amounted to a 6.5% increase from the $76 million in sales recorded in the fiscal third quarter of 2002.

    Guess which stock is up more in the last three months? Calavo Growers, which began life as an avocado cooperative in California and bills itself "the first name in avocados," gained 16% in the period. GE is down 1%.

    10 Likely Micro-Cap Winners



    In other words, the way to make macro profits from the current economic recovery is by putting some money in micro-caps. And I've put together two screens and followed up with some due diligence on individual stocks to identify 10 micro-caps likely to outperform the average stock.


    10 Micro-Caps Under the Microscope
    Sometimes good stocks come in little packages
    Stock Industry Market Cap ($ million) Shares Outstanding (million) Analysts Covering Stock YTD Return
    American Vanguard (AVD:NYSE) Agricultural chemicals $166 5.8 0 94%
    Atlas Pipeline (APL:NYSE) Natural gas pipelines 152 4.4 1 46
    Calavo Growers (CVGW:Nasdaq) Avocados and produce 108 12.9 0 19
    Cohesant Technologies (COHT:Nasdaq) Adhesives 14 2.6 0 38
    Concorde Career Colleges (CCDC:Nasdaq) Education and training 124 5.9 0 67
    Fargo Electronics (FRGO:Nasdaq) Business software and services 166 12.4 4 53
    Great Northern Iron Ore (GNI:NYSE) Iron ore 132 1.5 0 50
    Middleburg Financial (MBRG:Nasdaq) Banking 141 3.8 1 62
    Onesource Information Services (ONES:Nasdaq) Internet information 117 11.3 2 34
    Silent Witness (SILW:Nasdaq) Security and protection services 64 7.5 0 109
    Source: MSN Money



    OK, so what's a micro-cap stock, anyway? And how did I put together this list of what I believe are good ones?

    These Aren't Penny Stocks



    A micro-cap isn't the same as a penny stock. The latter term is used for any stock that sells for a low price per share, often $5 or less. A micro-cap stock, on the other hand, can sell for a high price per share: For example, Great Northern Iron Ore ( GNI), another stock that made my micro-cap list, sells for $89 a share.

    What makes a micro-cap a micro-cap is the combination of price per share and a very small number of outstanding shares. Great Northern Iron, for example, has only 1.5 million shares of stock outstanding. Contrast that with the 10 billion shares of General Electric stock outstanding.

    Multiply the price per share and the number of outstanding shares, and the total market capitalization of Great Northern Iron is a tiny $133 million, despite its high share price. General Electric, on the other hand, trades for a lower price per share of $28 but has a much higher market capitalization of $280 billion because the company has issued so many shares.

    By my definition, then, if you ranked all of the stocks in the market by market capitalization, the micro-caps would be those in the lower 25% of the pyramid, with a market capitalization of $200 million or less.

    Before you dive into the micro-cap market, you should know that there is a downside. (There's no free lunch in investing.) Because there are so few shares outstanding, very few shares of these stocks trade on the average day.

    Average daily trading volume for Great Northern Iron, for example, is just 2,300 shares. That can make it hard to get in and out of positions even for individual investors. And it certainly makes it impossible for most large institutional investors to buy these shares.

    Sifting for Winners

    How do you identify good investments in the world of micro-caps? Forget about Wall Street analysts. As you can see in the table above, most micro-caps aren't followed by any analysts. That's not surprising. Because there's almost no institutional buying or selling interest in these stocks, Wall Street doesn't have a reason to produce research on them. Micro-caps aren't exactly profitable investment banking clients, either. So count out investment banking fees as motivation.

    In the micro-cap world, stock screens -- and word of mouth -- are an investor's best friends. To come up with my list of 10 micro-caps for macro profits, I tweaked two screens that I built recently to look for unknown mid-cap blue-chips. You can see my original thinking on unknown stocks in my Oct. 15 column . For cash-cow stocks, see my Oct. 22 column .

    The simple tweak? Instead of ruling out all stocks with market caps of under $200 million, I required every stock on the list to have a market capitalization of $200 million or less.

    After due diligence on the 27 stocks that made the first cut of either of these two screens, I wound up with nine micro-cap candidates. I added one stock that didn't make either list, Calavo Growers, but had popped up on my personal radar a few months back.

    What do these stocks have in common? Not their structure, their industry, their market share or their technologies.

  • Higher yields. Atlas Pipeline Partners (APL) and Great Northern Iron Ore are structured as a partnership and a trust to pass almost all earnings through to investors. Atlas yields 6.6%, while Great Northern Iron yields 7%.
  • Niche dominance. Some, like Calavo Growers, are dominant companies in small niches that are using profits to expand into new markets. In Calavo's case, that means selling avocados to new customers in Japan, where sales grew by 40% in the most recent quarter, and adding papayas and prepared foods to its product line.
  • Scavenging. Others thrive by being tough competitors in a business dominated by larger companies. Agricultural chemicals producer American Vanguard (AVD) is finding a way to make a profit by buying product lines that larger companies have abandoned.
  • Hot trends. Education and job training in the case of Concord Career Colleges (CCDC), and video security and surveillance gear in the case of Silent Witness (SILW).
  • New blood. Others on my list have found growth in "old" industries such as adhesives (Cohesant Technologies (COHT)) and banking (Middleburg Financial (MBRG)).
  • But because I started with two screens that emphasize cash flow and consistent earnings growth, these micro-caps share many of the fundamental characteristics of their larger blue-chip brethren. (Although because of the volatility that comes with smaller daily trading volumes, I wouldn't put any of these stocks in the blue-chip category. They're intrinsically riskier than that.)

    Consistently Strong Returns

    For example, Silent Witness shows a return on equity of 35% over the trailing 12 months. Return on equity was 31% at Concorde Career Colleges, 25% at Onesource Information ( ONES).

    Fargo Electronics ( FRGO) shows positive year-to-year earnings growth in seven of the last eight quarters. Middleburg Financial has delivered that kind of growth even more consistently, with year-to-year earnings growth in each of the last 10 quarters.

    You'll find consistency on the performance side, too. American Vanguard's worst performance in the last five years is a 3% loss in 1998. Cohesant Technologies shows an annualized average return of 30% over the last five years.

    I think those kinds of numbers stack up against those delivered by much larger companies.

    Good stocks can come in small packages.
    At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jim Jubak at jjmail@microsoft.com.