2 Small-Cap Winners In A Market Full Of Losers

Includes: AUTH, SIMO
by: Joshua Hayes

This is a tough market for trend-followers to make money in. Most trend followers, like myself, are holding on to their short positions they initiated back in July through August. Since the August 8th lows the market has been stuck in a volatile trading range where solid profits are very difficult to come by. I have personally spent more time cutting losses than enjoying any meaningful gains.

The current state of low volume rallies following very heavy periods of distribution has been going on all year and makes investing in stocks a very dangerous game. Normally, to put all the odds on your side to make significant profits in the stock market you want a market trending higher above the 50 and 200 day moving averages and you want this move to come with strong accumulation (volume above the 50 day volume average).

Since we have a tape filled with distribution and no accumulation, buying stocks here is just not the smart thing to do. Instead of trying to buy stocks in a poor tape, history suggests that it is wiser to stay in cash. That doesn’t mean while you are in cash you should be lazy. Despite being heavy cash, holding some shorts, and being long two inverse ETF positions, I am always ready for the next rally attempt.

When the market makes a big move on big volume and I can find new innovative companies that have big earnings and sales growth, I will be ready to go long. While I wait for a signal to buy stocks, I hunt for the possible future winners. In a previous article I profiled some small-cap under-the-radar stocks that are definitely off of Wall Street’s map. Tonight I have another two that must be reviewed as future potential stock market leaders.

Let’s start with my favorite: Silicon Motion Technology (NASDAQ:SIMO). Silicon Motion Technology is a Taiwan based designer of microcontrollers, universal serial bus flash drives, card readers, and embedded flash. This is a very high growth industry and the numbers below prove this.

Silicon Motion Technology has been able to grow EPS during the last five quarters by 200%, 433%, 148%, 999%, and 233%, compared to the previous year. Sales growth during the past six quarters has been just as impressive with gains of 21%, 56%, 47%, 83%, 65%, and 59%. During the past eight months sales have gone from $23.7 million to $50.7 million. This is extremely solid growth.

Future EPS estimates are just as impressive as the past and current EPS growth. 2011 and 2012 expected estimates were raised once again projecting gains of 118% and 21% respectively. Based on future estimates the current P/E ratio of 14 makes the stock appear to be a bargain at these levels -- especially since it is trading around the low of its historical 5-year range between 2 and 41.

The company also has 0% debt to shareholder equity, a Return on Equity of 9%, and a cash flow of $0.65. On top of these sterling numbers, the company is obviously committed to continued growth as it spends 26.8% of its revenue on Research & Development. This proves to me the company has what it takes to innovate and the ability to stay ahead or keep up with changes in the industry.

It is always important to see mutual fund sponsorship in these young stocks if they are going to be able to continue to climb higher. Without these mutual funds investing their large sums of money any potential future leader has no chance.

Luckily, for Silicon Motion Technology, mutual funds are definitely getting interested again as fund ownership has increased from 27 funds two quarters ago to 37. I would like to see management own more than a 6% of the shares outstanding but this company is not exactly “new” having entered the market back in 2005.

Our next stock is a bit more speculative: AuthenTec (NASDAQ:AUTH) is a Melbourne, FL, designer of fingerprint authentication sensors for personal computing, wireless, home security, and access control markets. Once again, here we have another high growth industry.

During its entire existence AuthenTec has not been able to turn a profit. That is going to change at the end of the year when the last quarter should be the start of some solid earnings growth based on current sales growth and the amount spent on R&D. After finally turning a profit in the final quarter of the year, 2012 annual EPS growth estimates are for 0.04. This will give Authentic its first annual profits since going public in 2007 on the Nasdaq.

During the past six quarters, compared to the year before, sales growth has come in at 30%, 27%, 0%, 75%, 69%, and 51%. The company has almost doubled its sales from $8.3 million seven quarters ago to $16.2 million as of the most recently reported quarter.

The good news about AuthenTec is that is has 0% debt to shareholder equity but the flip side of that is that current cash flow is a $-0.84. This number will have to see some improvement to get more mutual funds to invest in the company. I am sure that can be done, since the company is projected to be profitable soon and currently spends 46.3% of its revenue on Research & Development. This number is beyond interesting to me as some of the best young growth companies in the history of the stock market have spent like this on their R&D. If anything it shows this company believes in its products and expects big things in the future.

Mutual fund ownership is also going the wrong way from 56 funds four quarters ago to 47 as per the most recently reported quarter. Despite this, the stock is clearly moving higher on heavy accumulation. My take on this is smarter funds are replacing the weaker funds. These new funds are investing more capital in the stock than the previous funds did. This is why the heavy accumulation is very visible on the chart despite fund ownership falling.

If the market stages a real follow-through day where leading stocks with top fundamentals are breaking out then I will be more than happy to look for entry areas in these stocks. In a higher trending market, I normally like to enter at support at the 50 day moving average, a pocket-pivot point off the 10 day moving average, or a breakout from a well formed basing pattern. In this current market, any buy is simply too dangerous. When the time is right, these stocks have the opportunity to make investors very wealthy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.