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To find strong small-cap stocks, the Forbes Best Small Companies list is a great place to find ideas. While tens of thousands of investors may read it, I doubt many actually take action on the companies. That's where you and I can be different. If you haven't already, download this spreadsheet of the top 50 Forbes stocks.

To recap, the method used by Forbes in finalizing these strong small-cap stocks is quite simple:

  • strong sales and earnings growth
  • publicly traded for at least a year
  • generate annual revenue between $5 million and $1 billion
  • stock price no lower than $5 a share
  • excluded financial institutions, REITs, utilities, and limited partnerships
Let me go through the strong small caps from No. 4 to No. 10. You can read about Nos. 1-3 here.

No. 4: Sturm, Ruger & Co. (NYSE:RGR)

Sturm, Ruger & Company, Inc. is engaged in the design, manufacture, and sale of firearms to domestic customers. The company operates in two segments: firearms and investment castings. The firearms segment manufactures and sells rifles, pistols, revolvers, and shotguns principally to a select number of licensed independent wholesale distributors primarily located in the United States.

Highlights

  • Sales growth of 16%
  • EPS growth of 99%
  • ROE of 24%
  • Using the DuPont Analysis spreadsheet, RGR’s ROE has increased primarily due to an increase in margins -- a great sign
  • Decreasing cash conversion cycle
  • Underwent a successful turnaround from 2008 with current management

Lowlights

  • After the horrific Sandy Hook massacre, talk of gun control has made itself heard -- from the highs, RGR is down 30% in just a matter of days
  • Lots of political risk

Valuations

Fundamentals have been very strong since 2008. What is most impressive is the strength of the ROE, ROIC, and CROIC from 2008. Inventory turnover has steadily increased from one turn in 2008 to 21 turns in the last 12 months. With no debt, RGR is in fantastic health and the Piotroski spreadsheet gives it a score of 7 with no signs of manipulation by the Beneish score. The growth from 2008 has purely been organic, which is exceptional.

However, with the political risk involved and possibility of tighter gun control, I would not be surprised to see the intrinsic value to drop. If RGR can continue this growth, then the Graham model suggests that $58 is a fair value, Katsenelson's absolute P/E method comes up with a default fair value of $62, but adjusting the score for business risk and earnings predictability, the number drops to $51.

The reverse DCF shows that with a starting FCF of $40 million and 12% discount rate, RGR has to grow at 17% to match the current expected price of $44. Lowering the growth rate to 9% has a value of $30.

No. 5: Metropolitan Health Networks (MDF)

Over the past years, I have noticed that quite a decent number of companies get bought out. This is a sign that the metrics Forbes is putting together is something that companies also look at when it comes to acquisitions. Not long after releasing the 2012 list, MDF has been bought out.

No. 6: IEC Electronics (NYSEMKT:IEC)

IEC is a provider of electronic contract manufacturing services to advanced technology companies. The company specializes in the custom manufacture of circuit cards and system-level assemblies, an array of cable and wire harness assemblies, and precision sheet metal components.

Highlights

  • Sales growth of 40%
  • EPS growth of 79%
  • ROE of 39% (not quite sure how Forbes calculated it; I get 18.5%)
  • The three-step DuPont analysis is flat and doesn’t tell much, but the five step DuPont analysis shows that the growth in operating margin has been the key driver for the ROE -- great to see

Lowlights

There isn't much to nitpick with IEC. I previously wrote about IEC because they were listed at No. 3 in the 2011 best small companies list.

Although debt makes up half of total assets, this level has been consistent and looks like the level at which IEC operates. The only other point to consider is that you will not be getting any dividends or special dividends from this company. Management is also compensates themselves very well.

Valuations

Taking a quick look at its competitors, if IEC got to a EV/EBITDA multiple of 10, it would be worth $11. Following the Katsenelson absolute P/E valuation, the fair value P/E comes out to 10, which makes it worth $7.60 because earnings predictability deducted some points.

Although ROE is high for the company at 18%, compared to the competition, IEC has the best fundamentals. DCF comes out to around $10. Graham’s formula is overoptimistic at $16.

No. 7: Questcor Pharmaceuticals (NASDAQ:QCOR)

Questcor Pharmaceuticals is a biopharmaceutical company. The company's primary product is H.P. Acthar Gel (repository corticotropin injection), an injectable drug that is approved by the United States Food and Drug Administration, for the treatment of 19 indications. As of Dec. 31, 2011, H.P. Acthar Gel was approved for the treatment of acute exacerbations of multiple sclerosis in adults, and as monotherapy for the treatment of infantile spasms in infants and children under two years of age.

Highlights

  • Sales growth of 61%
  • EPS growth of 20%
  • ROE of 54%
  • The company has initiated a share buyback program
  • Here is the DuPont analysis for the way QCOR has been growing

(click to enlarge)

Lowlights

With such fast growth, it is difficult to trust multiples, so the safest bet would be use a method like the DuPont to see which aspects of the business is generating the returns. The accruals of the company are deep in the red and this is something to look deeper into.

The company has a great amount of uncertainty and fear over a government investigation about its drug Acthar Gel. Aetna has stopped reimbursing patients, but the company is showing huge increases in the number the number of Acthar vials sold.

Valuations

I'm not an expert with valuing bio stocks,especially ones with such fast growth, but if you take a look at the financial statements, growth has been exponential and there is high uncertainty.

  • DCF with 25% growth shows $42
  • Graham shows $112
  • Absolute P/E shows $40
  • No growth EPV is $20, with net reproduction value of $2.40 (large moat)

No. 8: Cirrus Logic (NASDAQ:CRUS)

Cirrus Logic, Inc. is a United States-based company that supplies high-precision analog and digital signal processing components for audio and energy markets.

Highlights

  • Sales growth of 21%
  • EPS growth of 64%
  • ROE of 20%

Lowlights

  • Valuation ratios are pricey
  • EV/EBITDA of 15
  • P/S of 3.7
  • P/B of 3.7
  • P/OwnerEarnings of 8.5

Valuation

This article on Forbes says that CRUS is priced too low. Using their own expectations of 15% growth, my calculation is $30 on the low end and can go up as high as $60 on optimistic earnings and growth rates. I won't spend much time on CRUS as it doesn't interest me.

No. 9: Rue21 (NASDAQ:RUE)

A specialty apparel retailer. The company operates 713 stores in 46 states throughout the United States. It offers a line of apparel and accessories for girls and guys, including graphic t-shirts, denim, dresses, shirts, hoodies, belts, jewelry, handbags, footwear, intimate apparel and other accessories.

Highlights

  • Sales growth of 28%
  • EPS growth of 38%
  • ROE of 55%
  • Only clothes retailer to be in the top 10
  • Compared to AEO, ARO and ANF, RUE beats them all in fundamentals
  • I only recently heard about this small-cap company, but it has been impressive since it became public (read this article to see more highlights)
  • The company maintains a solid balance sheet with approx 10% of its assets in cash
  • This fast-growing retailer almost doubled revenues from FY 2009 to FY 2012 and still sells for a five-year projected PEG of under 1 (0.78)
  • The stock sells at approximately eight times operating cash flow and the company used that cash flow to purchase 2% of its float in the recent completed quarter

Lowlights

  • Valuation ratios are pricey

Valuation

Seeing as how I still hold a small losing position in ARO, I may switch it over to RUE if I wanted to buy a retailer. The company has better growth prospects, better fundamentals, and is lesser known. Valuation-wise, it is on par with competitors.

Despite the strong expected growth, the company has no moat as can be seen by the EPV.

Capital expenditures have been increasing as the company continues to expand, and with it maintenance capex is also increasing. Notice how the net reproduction value and EPV is similar. This shows that the company does not have a moat.

No. 10: Medifast (NYSE:MED)

Medifast, Inc. is engaged in the production, distribution, and sale of weight management and disease management products and other consumable health and diet products. Medifast's product lines include weight and disease management, meal replacement, and vitamins.

Highlights

  • Sales growth of 36%
  • EPS growth of 41%
  • ROE of 23%

Lowlights

I am wrong so far in my prior assessment of MED. I previously wrote about how I thought MED was a pyramid scheme, but the company, fan base, and franchises have proven me wrong.

Based on the big stock run-up, valuation ratios have increased a lot and the DuPont analysis shows that in 2010, 2011, and TTM, the ROE is falling due to a drop in margins, which is a worrying sign.

(click to enlarge)

The Piotroski score has fallen to four in the TTM, and in 2011 the Beneish M score showed red for the first time since 2003 -- a possible sign of earnings manipulation.

Valuation

MED turned it around in 2009, and looking at the company from 2009 to 2012, I come up with the following fair values.

  • DCF: $25 with 15% growth
  • Graham formula of $35 using analyst EPS estimates
  • Absolute P/E of $35
  • No growth EPV of $27
  • 10x EBIT of $14

Disclosure: None.

Source: 6 Strong Small-Cap Stocks To Take You Into 2013