Panning for Small- and Mid-Cap Gold

NEW YORK ( TheStreet) -- My column yesterday on Hillenbrand ( HI) referenced one of the stock screens I use to find compelling small- and mid-cap names.

It often reveals companies that are a couple of cuts above some of the deep value techniques I utilize, in terms of quality. This particular screen combines the quest for companies with solid net profit margins, and growing, sustainable dividends.

More specifically, it includes the following criteria:
  • Market capitalization between $100 million and $5 billion.
  • Net profit margin of at least 8% for the trailing 12 months and for the latest fiscal year.
  • Dividend yield greater than 1%.
  • At least four consecutive years of increasing dividends.
  • Payout ratio less than 50%.
  • Price-to-earnings ratio less than 20.
  • No financial stocks.

When I ran the screen this past May, only seven names made the cut: Lancaster Colony ( LANC), Carbo Ceramics ( CRR), Hillenbrand, W&T Offshore ( WTI), Sturm Ruger ( RGR), American States Water ( WTR) and McGrath RentCorp ( MGRC). Combined, these seven names are up an average of a bit more than 13% in the past six months. That's significantly better return than both the S&P Small Cap Index (up 6.2%) and the S&P Mid Cap Index (up 5.53%).

Although I think this screen has some merit, a six-month time frame is too short to make a judgment. I've seen screens produce great results in the short term but fall apart longer term, and vice versa.

In the cases of the seven companies that made the list in May, six of them have had positive returns. The exception was Carbo Ceramics, which is down 8%. Skewing the results is the performance of gun name Sturm Ruger, which is up 42%. Out of the five remaining names, four were up double digits. Still, seven companies is a small set, but it demonstrates the stringent requirements of this screen.

While Lancaster Colony (P/E is now above 20) and McGrath RentCorp (payout ratio is now 51%) don't make the cut now, there are some new qualifiers. These include electronic products name Hubbell ( HUB.B), welding products company Lincoln Electric Holdings ( LECO), Tupperware Brands ( TUP), Dun & Bradstreet ( DNB), chemical name NewMarket ( NEU), energy holding company Energen ( EGN), anti-aging personal products company Nu Skin Enterprises ( NUS), publisher John Wiley & Sons ( JW.A), filtration products company CLARCOR ( CLC), flavor and fragrance name Sensient Technologies ( SXT), industrial manufacturer Raven Industries ( RAVN), information technology name Computer Services ( CVSI) and medical instruments and supplies company Mesa Laboratories ( MLAB).

All in all, it's a fairly eclectic group of 18 companies, many of which are not well-known by investors. In terms of portfolio statistics, this group has an average market cap of about $2.2 billion, a trailing P/E of 15, average dividend yield of 2%, and trailing 12-month net profit margin of 12.3%.As I sometimes do when I identify screens that might have some merit, I will track this group of names moving forward, as an index.

At the time of publication, Heller had no positions in stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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