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The sharp retreat in certain parts of the market over the past few weeks has been very cruel to micro caps. According to Russell data, their Micro Cap Index, which consists of the bottom 1000 names in the Russell 2000 in terms of market cap as well as the next 1000 names, is down 5.17% in May, which is sharply lower than the return on the S&P 500 of 2.06%.

The Russell 2000 index of small caps is down 4.13%, suggesting that the smaller the stock, the worse it is getting hit. Why? I believe that a couple of things are going on, including a flight to quality/liquidity, which is reflected in the strengthening dollar, rallying Treasuries and the strong performance of certain sectors like Utilities and Healthcare, and relative pessimism among smaller investors who typically have more impact on smaller stocks than larger ones.

With this in mind, I wanted to design a screen to identify dirt-cheap smaller companies. Here is what I did (and why):

  • Market Cap between $100mm and $1bln
  • Enterprise Value/EBITDA < 6 (low valuation)
  • Price to Tangible Book < 4 (valuation)
  • Net Debt to Capital < 5% (strong balance sheet)
  • Sales Growth last 4 quarters > 0% (growing)

The total list had 87 names that I have posted to my private blog, My Own Analyst. The companies came from many different economic sectors and typically had P/TB ratios below 2. We own 5 of the names in the Top 20 Model Portfolio. Interestingly, as I ran the same parameters for larger companies, two of our other holdings, which are mega caps, as well as a mid cap would make the cut as well. So, clearly I am attracted to these types of valuations and characteristics. I have selected 7 from the complete list, including some that I own as well as few interesting others. Here are the 7 (click to enlarge images):

The names are sorted on EV/EBITDA. I also included a column for YTD price return, which shows that all of these are down, with one down sharply and one absolutely hammered. Let's start at the top.

  1. I included Advanced Battery (OTCPK:ABAT) because it illustrates a point that should be obvious but apparently isn't: This is the beginning of a due diligence process and not the end. DON'T BLINDLY BUY THESE STOCKS! I have had one or two people complain to me when I share a screen like this and they buy the stock and it tanks. ABAT would have made this list BEFORE it plunged at the end of March following a negative research piece published on Seeking Alpha by Variant Research. I don't know the story fully, but I am highly skeptical of Chinese reverse mergers generally.
  2. Rimage (RIMG) is too cheap to believe. Investors clearly are missing the fact that the company has so much cash ($11 per share roughly, after netting out deferred revenue). I have been aware of the company for several years and have wondered about its future (historically it has made a living from folks buying picture CDs at Walgreens and other retailers on its machines). 2/3 of sales are from consumables and are highly recurring. The company changed its sales model last year, began repurchasing stock late in the year and initiated a dividend earlier this year. It has a new 46-year old CEO too, a 20-year Seagate veteran who joined in 2009 as COO and was promoted in early 2010. Royce, FMR, BlackRock and Ameriprise own almost 40% of the company, while insiders own another 5%.
  3. Vaalco Energy (NYSE:EGY) also strikes me as almost too good to be true. The bulk of their activities are in Western Africa, which may be the issue. CEO Gerry, who is 73 and has been at the helm since 1997 and owns 6% of the company, with other insiders owning an additional 4%.
  4. Oplink (NASDAQ:OPLK), which makes optical networking components and sub-systems, had been on a tear, growing sales and earnings dramatically in recent years but hitting a wall recently. On a forward PE basis, the stock, at less than 15PE, is near the lowest valuation levels in years. The EV/EBITDA valuation is possibly overstated, as it excludes short-term investments of $121mm. Cash and short-term investments total $196mm, with no debt and total liabilities of just $31mm. The cash works out to almost $10 per share. The CEO owns 7.5%, with total insider ownership at 12.5%.
  5. Shoe Carnival (NASDAQ:SCVL) is one that I have followed for years and include in my Top 20 Model Portfolio (since late January). I like the very large inside ownership (32%), the $5 per share in cash net of debt and the growth. Sure, it's boring (a shoe store), but they just reported their best quarter ever and have several growth initiatives, including e-commerce as well as store expansions.
  6. Kimball International (NASDAQ:KBALB) is a name that I also include in my Top 20 Model Portfolio. The company, which used to make electronic organs, is now a global EMS company as well as a furniture maker (go figure!). The EMS business is growing and is focused on low-volume production in several areas, including medical devices, automotive, industrial control and public safety. The furniture business serves offices and hotels, with a high-end and mid-range offering. This business has been very depressed but is now rebounding nicely. My sum-of-the-parts analysis suggests the stock is worth over $11. Insiders own over 12% of the company (through A shares or the voting stock primarily).
  7. Finally, GSI Technology (NASDAQ:GSIT) was just hammered recently on a near-term reduction in its outlook. The stock has returned to its levels from last summer, when a client of mine asked me to look at the stock. I am no expert on SRAM and appreciate the high concentration they have with customers Huawei and Cisco (NASDAQ:CSCO), but this price looks very attractive to me. Insiders own 23%, including almost 10% by the CEO, who founded the firm 16 years ago.

These are just 7 examples from a much larger list, but I hope you can see that the opportunities abound in small caps. While I don't expect small caps to necessarily continue to dominate their bigger peers as they have over the past decade, as I described in late-March when I expressed some caution on small caps, this is very fertile hunting ground that is likely to reward good research.

Source: 7 Dirt-Cheap Small Caps That Are Growing