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5 Small-Company Stocks To Consider

|About: BofI Holding, Inc. (BOFI), BRKL, CMD, EGOV, MKTX
Summary

Small-company stocks can be rewarding investments because of their generally higher growth profiles.

Small-company stocks are difficult to find because Wall Street analysts typically don't cover small companies.

Using BetterInvesting-style parameters for growth and quality, we identified five potential candidates: BOFI, BRKL, CMD, EGOV and MKTX.

This article by Adam Ritt, BetterInvesting's director of communications and editor in chief of BetterInvesting Magazine, includes discussion of companies that are mentioned only for educational purposes. No investment recommendations are intended.

BetterInvesting's approach to investing in stocks comprises several common-sense ideas. To review ideas discussed in previous posts, BetterInvesting-style investors seek the following types of companies:

1) They've proven they can grow sales and earnings. 

2) They're growing at rates suitable for their size. For small companies with less than $1 billion in annual revenues, that means 12% or more. For midsize companies with annual revenues of $1 billion to $10 billion, the minimum we seek is 7% a year. For large companies, the minimum is 5%.

3) They've shown consistent growth in sales and earnings, which indicates quality management. 

4) They have stable or growing pre-tax profitability and return on equity. 

Small companies are important for investors because their overall higher rate of earnings growth relative to larger companies powers their stock price, with periods of outperformance. It can be difficult to find suitable small companies to study because they typically aren't covered by Wall Street analysts.

A stock screen is one of the most effective ways to uncover small companies that might provide the quality and investment potential BetterInvesting-style investors seek. For this screen, we used MyStockProspector.com, which is operated by ICLUBcentral, a subsidiary of BetterInvesting.

We asked for small companies with revenues below $1 billion annually and long-term annual sales and EPS growth of at least 12%. We also wanted consistent growth for two reasons:

1) Consistent growth indicates quality management.

2) We'll have more confidence projecting future sales and earnings growth rates if growth is consistent.

The R2 calculation is a measure of consistency. When you look at a graph of sales and earnings growth, as on the Visual Analysis section of BetterInvesting's Stock Selection Guide, the individual lines are increasingly straight as the R2 value approaches its maximum of 1.0.

For this screen we sought an R2 for earnings and sales growth for the last 10 years of at least 0.80. That's a high hurdle to clear — only 212 stocks had 10-year R2s of 0.80 or above.

As an additional management test, we wanted companies with stable or growing pretax profit margins and return on equity. MyStockProspector compares recent PTP and ROE results with the five-year average. 

These growth and quality parameters are quite demanding, and only six companies passed the test:

1) BofI Holding (BOFI)

2) Brookline Bancorp (BRKL)

3) Cantel Medical (CMD)

4) NIC Inc. (EGOV)

5) MarketAxess (MKTX)

We've included the stock's current P/E on the spreadsheet attached to this post. It isn't enough to find growth stocks displaying consistent and quality; valuation is critical, especially when we've had such a long bull market. And historically, the long-term investment returns of high-P/E stocks have been disappointing.

Screens are just Step 1 in conducting stock studies. Do your research and assess the future investment potential of any stocks of interest. 

SmallCapScreen0718.xlsx

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