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Dynamite Comes In Small Packages: 10 Small Caps For Explosive Returns

Summary

10 undervalued small-cap opportunities for high total return.

The major advantage and disadvantage of investing in small caps.

Not all small caps are the same, choose wisely.

Introduction

Investing in small-cap stocks is not for everyone. My definition of small-cap is a company whose market is $5 billion or less. However, for those brave souls that are willing to assume a little more risk, they can, under the right conditions, be a very profitable choice. Nevertheless, and in the general sense, small caps offer both advantages and disadvantages that I believe should be clearly understood before utilizing this asset class.

There was a time when I invested heavily in fast-growing small- and mid-cap companies. As I have matured (aged), I have significantly curtailed my small- and mid-cap investments. However, I still dabble a bit, because although riskier, the right small- or mid-cap investment can produce outsized rewards. Therefore, and at the request of a few regular readers of mine, I offer this brief introduction into small-cap investing.

The Major Advantage of Investing in Small Caps

On the positive side, there is a theoretical mathematical advantage to investing in smaller enterprises. A small company operating in a growth industry can often grow much more easily and faster than its larger counterparts. Here is where the law of large numbers comes into play. In theory, it is easier for a $1 billion company to grow into a $2 billion company than it would be for a $100 billion company to grow into a $200 billion company.

The history of McDonald's (NYSE:MCD) is a case in point. In 1954, multi-mixer salesman (milkshake machines) Ray Kroc called on a San Bernardino, California restaurant run by Dick and Mac McDonald. Impressed by their operation, Ray pitched his vision of creating McDonald restaurants all over the United States. Although I cannot precisely verify it for sure, I believe there were only four McDonald's restaurants when Ray eventually purchased the exclusive rights to the McDonald's name.

But assuming that I'm reasonably correct, it's easy to understand that growing from four restaurants to eight restaurants (doubling in size) was an easily-achievable task. In other words, early growth of a successful restaurant operation was relatively easy. However, today McDonald's has over 36,000 restaurants. Therefore, it is also easy to understand that going from 36,000 restaurants to 72,000 restaurants (doubling in size) would be an almost impossible achievement. When high-growth is the objective, small size is a great advantage, and perhaps the greatest allure for investing in small caps.

The Major Disadvantage of Investing in Small Caps

On the other hand, small size can also be a great disadvantage. Smaller companies generally do not possess the financial strength and/or flexibility that their larger counterparts do. Consequently, they are often faced with capital restraints that can inhibit their ability to maximize their growth. Additionally, being small can also jeopardize their survival in a weak economy or market.

Furthermore, from the perspective of a passive shareholder, liquidity can also be a problem. Small caps typically have fewer shares trading, which often causes both liquidity and higher volatility issues. And, in the same context, smaller companies rarely pay a dividend because they generally need to keep and reinvest all or the majority of their available capital in order to fund future growth. For these reasons, and many more, small companies are clearly riskier investments than large blue-chip enterprises.

Not All Small Caps Are the Same

What I have written thus far about small caps has been very general in nature. However, as I have often written in the past, generalities do not universally apply. Consequently, I contend that the only thing that small caps truly have in common is smaller size. Just as it is with their larger counterparts, there are many more differences between individual small companies than there are similarities.

For example, not all small companies are growing. In fact, some small caps have become small because their businesses are shrinking. Therefore, investing in small caps should be no different than investing in larger companies. In other words, the same prudent investing rules apply. When investing in small caps, comprehensive research and due diligence becomes even of greater importance. Furthermore, when looking for a small-cap investment, selectivity is crucial. The central idea is to find the very best small company you can, with attractive growth prospects that is also available at a sound valuation.

10 Interesting Small-Cap Research Candidates

In preparation for this article, I started by screening the S&P 600 small-cap index looking for small-cap growth stocks trading at fair - or better yet - attractive value. In addition to growth and value, I was also looking for quality and operating consistency. Because of the risk of investing in small caps, I also put special emphasis and consideration on debt. Utilizing my premium subscription to F.A.S.T. Graphs™, I literally conducted an earnings and price correlated review of all 600 constituents in the index. Much to my surprise, I found very few small caps that I was willing to present as attractive-looking candidates for further research.

However, I was able to come up with 10 rather intriguing-looking small companies that were also attractive from a valuation perspective. On the other hand, the fact that I was only able to find a few small caps that even appeared attractive should be carefully noted. In other words, I didn't find a lot of value in quality small-caps today.

Nevertheless, I offer the following 10 small-cap research candidates listed in alphabetical order. The portfolio review lists them by ticker, name, sector, debt to capital, P/E ratio, price to cash flow, dividend yield, market cap, near-term estimated earnings per share growth and longer-term trend line estimated EPS growth.

Since many readers may not be familiar with each of these small-cap selections, I offer the following overview of each of the 10 research candidates. Courtesy of S&P Capital IQ, I included a short business description on each, followed by a few slide excerpts from each company's corporate presentations and a link to the full presentation. Additionally, I have provided earnings and price correlated historical F.A.S.T. Graphs™ on each with a calculated return forecast out to 2017 based on what I considered the most appropriate valuation reference line.

Note: I have moved the return calculation pop-up to the left corner of the graph so that it did not cover up important data listed in the FAST FACTS.

"Air Methods Corporation, together with its subsidiaries, provides air medical emergency transport services and systems in the United States. The company operates in the Air Medical Services ((NYSEMKT:AMS)), Tourism, and United Rotorcraft (UR) segments.

The AMS segment provides air medical transportation services to the general population as an independent service, as well as to hospitals and other institutions under exclusive operating agreements. Its services include medical care, aircraft operation and maintenance, dispatch and communications, and medical billing and collections. As of December 31, 2015, this segment's aircraft fleet consisted of 321 company-owned aircraft and 92 leased aircraft, as well as 54 aircraft owned by AMS customers and...


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