How to Find Attractive Small-Company Stocks

A stock screening tool is an essential part of any investor’s toolbox.

ICLUBcentral has long offered MyStockProspector.com, a web-based screening tool directed at long-term investors that helps to discover stocks meeting specific criteria such as rate of earnings per share growth, relative value, or pre-tax profit margin trends. Accessible from any Web browser, MyStockProspector.com uses 10-year company histories (courtesy of Morningstar, the same data used on our StockCentral website and by BetterInvesting in its stock analysis tools) and offers more than 120 different criteria to help investors to pinpoint stocks that meet their personal criteria.

Among the criteria available for searches are the most recent annual sales and the market capitalizations of companies. This allows you to target smaller companies in your screens, as we do when we sit down to find potential candidates for the Informer.

Without giving away our “secret sauce” for finding companies of interest, here are some of my thoughts and tips for building a stock screen using either MyStockProspector.com.

• Sales less than $2 billion.  This limits your search to companies that have revenues in the last 12 months less than $2 billion. While the definition of a “small” company proposed by BetterInvesting is for sales below $1 billion, our objectives cast a somewhat wider net.
• EPS and revenue growth in past three to five years greater than 10 percent. Smaller companies can’t be expected to have a full 10 years of history, so looking for companies with high growth in the past three years can find those with acceptable growth.
• EPS R2 in past three to five years greater than 0.75. R2 (“R-squared”) is a measure of the consistency of a series of points, so this figure looks for companies with a certain minimal level of consistency of growth.
• Debt/equity ratio less than 50%. Companies that are laden with debt may be less likely to perform well during economic hard times, so limiting the maximum amount of debt lessens the potential of this problem. To tighten up this area, set the limit at 33% or even to zero.
• Pre-tax profit margins are stable or increasing. MyStockProspector.com use a unique numerical rating system that evaluates a company’s pre-tax margin trends (thus allowing you to limit your results to companies that look good in Section 2 of the Stock Selection Guide). In the program, set the PTI rating to be greater than 3.

Now, view your results. You should have plenty of companies to study. If you have too many companies, then you can consider adding some additional criteria, such as:

• Stable or increasing return on invested capital. Similar to the PTP Rating described above, set the ROE rating to be greater than 3.
• Insider ownership > 15%. This means management’s interest is aligned with shareholders.
• Institutional ownership > 10%. Some institutional interest is desirable in order to support share price growth.

You’ll note that there are no valuation metrics included in the above criteria. My preference is to search first for quality companies, then review their valuations independently. If you wish to screen a bit deeper, however, here are some valuation criteria that you could include:

• PEG ratio between 0.75 and 1.2.
• Relative value between 0.75 and 1.2.

These won’t eliminate overvalued stocks completely, but they will isolate companies that may be closer to an attractive current buy price.
 

• DOUG GERLACH