5 High Quality Small-Caps That Pass the Strategies of Investment Legends

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Since the stock market began to turn lower two months ago amid renewed fears about the European debt crisis, small-cap stocks have fared worse than their larger peers. It shouldn't be a surprise -- often when fears hit and the market falls, investors lean toward stocks of larger companies, with the assumption that they will be more stable and steady during tough times.

Many quality small-caps can thus get unfairly punished during such periods, creating bargains among the market's little guys -- that's what my Guru Strategies (each of which is based on the approach of a different investing great) think is happening with many smaller stocks right now. And very often, investors who take advantage of such bargains get a big boost when the market turns, as smaller stocks outperform larger stocks when fears subside and investors begin to take on more risk. In 2010, for example, the market really began to turn upward after its summer doldrums on Aug. 30. Over the next three months, the S&P 500 gained about 12.6%; the Vanguard Small Cap ETF jumped more than 20%. Last year, after stocks bottomed on Oct. 3, the S&P rose about 16.2% over the next three months; the Vanguard Small Cap ETF gained more than 21%.

I'm not saying the market has bottomed, or that you should try to time the market. What's more important here is that many high-quality small-caps are trading on the cheap. So even if they don't snap back today or next week, they're still the sort of longer-term bargains you should consider for your portfolio. (And if they do happen to turn around sooner rather than later, all the better.) Here are several my models are high on right now:

L.B. Foster Company ( FSTR ): Pittsburgh-based Foster ($275 million market cap) makes rail, construction, and tubular products that range from rail joints to bridge decking to water well piping. My Benjamin Graham-inspired model is high on the stock. Graham, known as the "Father of Value Investing", was a very conservative investor, and this approach looks for companies with good liquidity (current ratio of at least 2.0) and a strong balance sheet (long-term debt should not exceed net current assets). Foster has a 3.2 current ratio, no long-term debt, and about $160 million in net current assets. It also trades for a reasonable 14.3 times three-year average earnings, and just 0.9 times book value.

Darling International ( DAR ): Darling ($1.7 billion market cap) is in the business of rendering -- turning animal by-products from butcher shops, grocery stores, food service companies, and meat and poultry processors into oils and proteins used by agricultural, leather, and oleo-chemical firms. It also recycles cooking oils used by restaurants, turning them into useable products like high-energy animal feed ingredients and industrial oils, and it recycles bakery waste into by-products like cookie meal (an animal feed ingredient).

Texas-based Darling has been an explosive grower, upping earnings per share at a 47% pace over the long haul (I use an average of the three-, four-, and five-year EPS figures to determine a long-term rate.) That makes it a "fast-grower" according to my Peter Lynch-based model -- Lynch's favorite type of investment. Lynch famously used the P/E/Growth ratio to find bargain-priced growth stocks, and when we divide Darling's 11.0 price/earnings ratio by that long-term growth rate, we get a P/E/G of just 0.23. That falls into this model's best-case category (below 0.5). While it will be tough to maintain such a high growth rate, the stock is cheap enough that it would be a bargain at even half its current growth.

The model I base on the writings of hedge fund guru Joel Greenblatt is also high on Darling. Greenblatt's approach is a remarkably simple one that looks at just two variables: earnings yield and return on capital. Darling's 14.9% earnings yield and 49.7% ROC make it one of the top 40 stocks in the market right now according to this approach.

Fred's Inc. ( FRED ): Memphis-based Fred's ($500 million market cap) operates more than 700 discount general merchandise stores in the southeastern United States. Like many discount retailers, it's done quite well in recent years, and my Lynch-based model likes its 22.2% long-term growth rate and 14.9 P/E. Those figures make for a bargain-priced 0.67 P/E/G ratio. It also likes that Fred's debt/equity ratio is a mere 1.7%.

My James O'Shaughnessy-based growth stock model also likes Fred's. It looks for firms that have upped earnings per share in each year of the past five-year period, which Fred's has done. It also looks for a key combination of variables: a solid relative strength, which is a sign the market is embracing the stock, and a low price/sales ratio, which is a sign it hasn't gotten too pricey. Fred's has a decent 12-month relative strength of 65, and its P/S ratio of just 0.27 comes in well below this model's 1.5 upper limit.

MWI Veterinary Supply, Inc. ( MWIV ): This Idaho-based medical equipment small-cap ($1.2 billion) keys on a very specialized group of end-users: animals. It sells its products, which include pharmaceuticals, vaccines, parasiticides, diagnostics, capital equipment, and pet food and nutritional products, to veterinarians in the U.S. and U.K. In the past year, it has taken in more than $1.8 billion in sales.

MWI has actually outperformed the market since the downturn, but my models still think there's value in the stock. It gets strong interest from my Martin Zweig-inspired model, which likes the firm's long-term EPS growth (24.9%) and long-term sales growth (22.0%). It also likes that EPS have increased in each year of the past half-decade, and that MWI's debt is less than 20% of its equity.

My Lynch-based model, meanwhile, likes MWI's 24.9% long-term EPS growth rate. Its P/E is on the high side (24.5), but the firm's growth is high enough that its P/E/G ratio still comes in at 0.98, just under the model's 1.0 upper limit. And my O'Shaughnessy-based growth model likes that it has upped EPS in each year of the past half-decade, and that it has an 82 relative strength and 0.66 price/sales ratio.

LSB Industries, Inc. ( LXU ): LSB manufactures a range of hydronic fan coils, water source and geothermal heat pumps, large custom air handlers and other products used in commercial and residential air-conditioning systems, as well as chemical products for mining, quarry and construction, agricultural and industrial acid markets.

Oklahoma City-based LSB ($620 million market cap) gets strong interest from the approach top money manager Kenneth Fisher laid out in his 1984 classic Super Stocks. Fisher pioneered the use of the price/sales ratio (PSR) as a valuation metric, finding it to be a better indicator than the more popular price/earnings ratio. This model looks for cyclical and industrial-type firms to have PSRs below 0.8. LSB's is 0.76, a good sign. The model also likes LSB's reasonable 26% debt/equity ratio, 26.2% long-term inflation-adjusted EPS growth rate, and three-year average net profit margins of 6.4%.

My Lynch-based model also likes LSB, thanks to its 28.6% long-term EPS growth rate and 8.5 P/E, which make for a stellar 0.30 P/E/G ratio. It also likes the company's reasonable debt load.

I'm long FSTR and MWIV.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: DAR , FRED , FSTR , LXU , MWIV

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