These Small-Cap Stocks Offer Upside And Safety


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Small companies typically outperform over time because they have greater growth prospects than themarket leaders. 

Between 1927 and 2012, for instance, small caps produced annual returns of 12.9%, compared with 9.9% for large companies. Even now, when many indices have hit highs, the S&P 600 Small CapIndex has gained 31%, in the pastyear compared with a 23%gain for the S&P 500 over the same period.

But most retail investors shy away from small caps mainly because they perceive them to be part of the seedy underbelly ofinvesting , the world of pump-and-dump boiler rooms. That reputation is not entirely undeserved. Manyilliquid companies exist whose financials are at best an educated guess. 

So to find small-capstocks that could be assumed to be reasonably safeinvestments , I used a several-step screening process, starting with solid fundamentals and substantialinsider andinstitutional ownership . 

Among companies with market caps of no more than $90 million, I found 23 that had positive returns onequity and assets, a forward price-to-earnings (P/E ) ratio, and institutional and insider ownership of at least 10%.

*of those with dividends

I compared the one-year returns of these stocks with the S&P 600 Small Cap Index. Anystock that had crossed below the index and was trending down was dropped, which left me with six contenders -- three of which paid dividends. Like many investors, I have a bias toward stocks that pay dividends, so let's look at those.

What I found were three companies which each have been on a solid growth trajectory.

Acme United ( ACU ) is a global supplier of cutting, measuring and safety products to consumer and industrial markets. It has neatly tracked the S&P small-cap index and shown the least volatility of the three stocks. While its $43.7 millionmarket cap is the lowest of the three, its nearly $14 share price is the highest. It has a forward P/E of 9.2, and itsdividend yield is the best of the three at 2.3%. In its most recent quarter, Acme posted a 7% increase innet income and a 3% rise inearnings .

On the institutional side, North StarInvestment holds nearly 400,000shares and has made more than a dozen insider purchases this year. Acme'sCEO , Walter Johnson, did sell 8,000 shares this month, but he still holds more than 350,000 shares.

Eastern Virginia Bankshares (Nasdaq: EVBS) is a bankholding company . It received $24 million in financialbailout funds , but it's been released from its agreement with regulators because it raised enoughmoney throughprivate placement . Its $66.7 million market capputs it in the middle of the group, although its share price is currently the lowest at just over $6. It has a forward P/E of 9.2, but its 1.1% dividend yield is the least of the three. Net income and earnings were down for the most recent quarter, mainly on charge-offs for non-performing and uncollectible assets and other losses.

EVBS' management and directors have been on a spree buying back stock this year, including 19 transactions in June alone at $4.55 a share -- nicely timed before the company said it had been released from itsTroubled Asset Relief Program (TARP) .

PzenaInvestment Management ( PZN ) is aninvestment manager catering towealthy families and other institutions. It has the largest market cap at $85.4 million, and its share price, although the highest at about $7, buys the most market cap per dollar of the three. It has a forward P/E of 14 and a dividend yield of 1.7%. For the most recent quarter,revenue grew 5.4% and earnings were flat. Although Pzena'sgross profit margin was down from the previous year, it remains a very high 45.2%.

Top holders include FineCapital , with nearly a quarter of a million shares, and Renaissance Technologies, with about 125,000 shares. Renaissance's bet on PZN is interesting because it usually is heavily invested inlarge caps .

Risks to consider: Neither past performance nor insider or institutional investment is aguarantee of future success.

Action to Take --> Together, these three stocks are quite promising. Due to the heavier institutional investment, I give PZN a slight edge over ACU. EVBS still has a way to go to prove itself, but now that it's free of the bailout program, it could really blossom.

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

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