Here’s how to find those hidden small-cap gems

  • After negative returns in 2015, small caps delivered in both 2016 and 2017, as the S&P Small Cap 600 Index returned 26.5 percent and 13.32 percent each year, respectively.
  • Small caps are immune to trade-war fears, economic expansion increases earnings more down cap than up and delayed benefits of the tax cut should help domestic-centric companies.
  • Pay close attention to volatility, use new online tools for research, find out how much attention people are paying to an opportunity, and don't be afraid to think local or regional.

Small-cap indexes have been rising in recent years, and many outlooks for 2018 are rosy. Yet indexes aside, greater opportunities this year may await investors who can identify promising small companies laboring in relative obscurity.

After negative returns in 2015, small caps delivered in both 2016 and 2017, as the S&P Small Cap 600 Index returned 26.5 percent and 13.32 percent each year, respectively. The index's one-year trailing returns as of this May 2 totaled 13.56 percent. And some forecasts call for 18 percent to 20 percent growth this year, ahead of large caps.

small-cap stocks
shulz | Getty Images

Buttressing optimism for the category is its immunity from the market's trade-war fears: Small companies don't tend to export much. Another factor is the tendency for economic expansion to increase earnings more down cap than up. Further, the delayed benefits of the tax cut should help domestic-centric companies proportionately more than multinationals. Small caps, which tend to pay higher effective tax rates, receive proportionately more tax relief from the legislation.

These factors doubtless will provide an extra boost for small companies that are already on the rise — and benefit investors looking for value in individual stocks. In a market where investors are constantly assaulted by data on large caps, many small companies aren't widely known. This makes them perennial fodder for the craft and sullen art of astute stock pickers seeking to exploit market inefficiencies. Typically, small caps on the launching pad or even taking off receive little or no touting from Wall Street, whose sell-side analyst ranks are thinning because of investment flows from active to passive management.

An estimated 45 percent of small-cap companies now have no analyst coverage whatsoever, and only about 20 percent have as many as five analysts covering them. And because of liquidity constraints, large small-cap funds tend to limit their purchases to larger small companies with sufficient trading volume — those with market caps above $500 million. Though these may not be covered by any analysts, inclusion in large funds can bring attention, while smaller small caps have a much lower profile. The paucity of analysts covering these companies is doubtless slowing the already glacial speed of information about them.

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For individual investors, the resulting market inefficiencies come with a conundrum. If news about the merits of potential winners travels slowly, how can they learn about it before it pushes up prices? How can they find and evaluate small companies that may be prospering, unbeknownst to most of the market?

Here are some moves to consider in the search for those hidden small-cap gems.

1. Pay especially close attention to volatility. Volatility can be friendly to small-cap value investors. If past periods of high volatility hold true, this year's herky-jerky market will likely foster a repeat of the baby-out-with-the-bathwater effect, in which lower trading volume punishes price disproportionately for small companies. This can create value opportunities for informed investors lying in wait for price dips.

2. Learn to use new tools available on low-profile radar screens. Some online screens providing myriad data are free of charge. To that point, CNBC.com has a free stock screener that's highly configurable. For example, an effective search for high-performing small companies with low profiles could use these five screens:

  • Market cap under $500;
  • Year-over-year revenue growth greater than 10 percent;
  • One-year EPS growth greater than 15 percent;
  • P/E ratio of 15 or less; and
  • Coverage by two or fewer analysts.

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In early April, these criteria produced 19 companies that are good candidates for closer analysis, depending on your goals and asset allocation. Other online tools can be purchased for reasonable annual subscription fees (in the low three-figures per year), making them sensible for individuals making sizeable allocations to small caps. Some provide aggregate performance scores reflecting various multiples.

3. Find out how many people are paying attention. Even if an otherwise attractive small company seems to have a relatively high level of analyst coverage, try to get a handle on how widespread market awareness of this company might be. How long a Google results queue does a company name generate?

If the Web profile seems low compared with those of other small companies, there's a good chance that few investors are going to learn of its emerging ascendance at least until the next quarterly earnings report or the Securities and Exchange Commission's Form 8-K, the latter being filed in the event of material change greatly enhancing profit potential.

"Local companies, especially in labor-intensive industries, tend to be on the minds of local people and, to the extent that these companies have a good local image, you might fall victim to familiarity bias."

4. Don't be reluctant to think locally or regionally. To the extent that filings trail results, observant locals may have better insights into small companies than people 1,500 miles away. Through local news media, you might learn of some promising new development, partnership or product before an 8K is issued or investors see nationwide news press releases on the PR Newswire.

This advantage over the rest of the country comes with a decided disadvantage — the potential for confirmation bias. Local companies, especially in labor-intensive industries, tend to be on the minds of local people and, to the extent that these companies have a good local image, you might fall victim to familiarity bias (as employees do when acquiring too much company stock without sufficient diversification). Don't confuse proximity with virtue.

By keeping these points in mind, you'll be better equipped to think small and pursue value opportunities unknown to most of the market

— By David S. Gilreath, partner and founder Sheaff Brock Investment Advisors

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