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Studies of stock returns going back to 1925 have suggested that "smaller is better." On average, the highest returns have come from stocks with the lowest market capitalization. Nevertheless this year so far, large-cap stocks have outperformed small-cap and mid-cap stocks.

Indexes Total Returns, Year to Date, are shown in the table below (Data through 10/08/2012):

In looking for future winners among small caps, I searched for stocks with strong growth prospects. Those stocks would have to show stable financial conditions and generate positive free cash flow. I looked also for companies where the average analysts' recommendation is buy or better.

I have elaborated a screening method, which shows stock candidates following these lines. Nonetheless, the screening method should only serve as a basis for further research.

The screen's formula requires all stocks to comply with all following demands:

  1. The stock is included in the S&P 600 index. S&P Custom Indices Fact Sheet explanation: "Introduced in 1994, the S&P SmallCap 600® is fast becoming the preferred small cap index in the U.S., covering approximately 3% of the domestic equities market. Measuring a segment of the market that is typically renowned for poor trading liquidity and financial instability, the index is designed to be an efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable."
  2. Earnings growth estimates for the next 5 years (per annum) is greater than 12%.
  3. Price to free cash flow is positive, (many investors prefer using free cash flow instead of net income to measure a company's financial performance, because free cash flow is more difficult to manipulate. Free cash flow is the operating cash flow minus capital expenditure).
  4. Total debt to equity is less than 0.5.
  5. The PEG ratio is less than 1.5.
  6. Average analyst recommendations are very bullish (less than 1.8).

After running this screen on October 09, 2012, before the market open, I obtained as results the 5 following stocks:

Aegion Corporation (NASDAQ:AEGN)

Aegion Corporation provides proprietary technologies and services for the rehabilitation and strengthening of sewer, water, energy, and mining piping systems, as well as buildings, bridges, tunnels, and waterfront structures; and the corrosion protection of industrial pipelines in North America and internationally.

Aegion Corporation has a low debt (total debt to equity is only 0.40) and the company has a low forward P/E of 10.74 and a low PEG ratio of 1.12. The average annual earnings growth estimates for the next 5 years is very high at 20.3%. Among the eight analysts covering the stock, four rate it a strong buy, three rate it a buy and only one rate it a hold. The AEGN stock seems to be a good investment right now.

Chart: finviz.com

Kaiser Aluminum Corporation (NASDAQ:KALU)

Kaiser Aluminum is a manufacturer of fabricated aluminum products for applications in the aerospace/high strength, automotive, general engineering and custom industrial markets. The company operates 11 facilities throughout North America.

Kaiser Aluminum has a low debt (total debt to equity is only 0.38) and the company has a relatively low forward P/E of 14 and a low PEG ratio of 1.29. The average annual earnings growth estimates for the next 5 years is quite high at 15%. Kaiser Aluminum pays a dividend, and the forward annual dividend yield is 1.74%. Among the six analysts covering the stock, two rate it a strong buy, three rate it a buy and only one rate it a hold. All these factors make the stock quite attractive.

Chart: finviz.com

Measurement Specialties Inc. (NASDAQ:MEAS)

Measurement Specialties is a leading global designer and manufacturer of sensors and sensor-based systems. The company produces a wide variety of precision sensors that use advanced technologies.

Measurement Specialties has a low debt (total debt to equity is only 0.42) and the company has a relatively low forward P/E of 13.41 and a low PEG ratio of 1.29. The average annual earnings growth estimates for the next 5 years is quite high at 15%. Among the four analysts covering the stock, two rate it a strong buy and two rate it buy. The MEAS stock seems to be a good investment right now.

Chart: finviz.com

Multimedia Games Inc. (NASDAQ:MGAM)

Multimedia Games is a preeminent supplier of gaming technology to Native American tribes. The company says that it further used its leadership position by diversifying into new markets, strengthening its strategic alliances, and pursuing dynamic opportunities worldwide.

Multimedia Games has a very low debt (total debt to equity is only 0.24) and the company has a very low PEG ratio of 0.80. The average annual earnings growth estimates for the next 5 years is very high at 25%. Among the four analysts covering the stock, three rate it a strong buy and one rate it a buy. The MGAM stock seems to be a good investment right now.

Chart: finviz.com

Materion Corporation (NYSE:MTRN)

Materion Corporation is an integrated producer of high performance advanced engineered materials used in a variety of electrical, electronic, thermal and structural applications. The company says that their products are sold into numerous markets, including consumer electronics, industrial components and commercial aerospace, defense and science, energy, medical, automotive electronics, telecommunications infrastructure and appliance.

Materion Corporation has a very low debt (total debt to equity is only 0.27) and the company has a low forward P/E of 11.78 and a PEG ratio of 1.45. The average annual earnings growth estimates for the next 5 years is 12%. Among the three analysts covering the stock, two rate it a strong buy and one rate it a buy. The MTRN stock seems to be a good investment right now.

Chart: finviz.com

Source: 5 Small-Cap Growth Stocks Analysts Recommend