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Small companies can offer big returns Add to ...

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a joint venture with Validea.ca, a premium Canadian stock screen service.

Since the explosion of the Internet nearly two decades ago, the nature of stock research has changed dramatically. Unlike the old days, when researchers and investors had to pore over stacks of newspapers and dog-ear pages of thick company reports, they can now get stock data almost instantaneously on financial websites, and download corporate reports in a matter of seconds.

One thing hasn't changed, however: Smaller stocks still tend to get lost in the investment research shuffle. While hordes of analysts track big companies such as AppleApple or Canadian National Railway,Canadian National Railway many of the little guys still fly under the radar. CN, for example, is followed by nearly 30 analysts, according to Morningstar; Apple is followed by over 50. Conversely, only four analysts track Pason Systems Inc. a $1.2-billion-market-cap oil and gas services company based in Calgary. (More on Pason in just a bit).

Just as analysts and institutional buyers (which are often too big to take a meaningful stake in small stocks) tend to overlook smaller stocks, so too do average investors. Because of that, smaller stocks are often a great place to look for bargains using fundamental analysis. If a big company is trading at very attractive valuations and has a pristine balance sheet, it's a good bet that legions of big investors will quickly be on to it. But with the little guys, a financially sound, bargain-priced firm can slide by unnoticed by the masses. If you have a good system for finding those high-quality smaller stocks, you can fare quite well.

One example is a small-stock-oriented model I developed that's based on the writings of Tom and David Gardner, the creators of The Motley Fool investment company. Since I started tracking it eight years ago, a 10-stock U.S. portfolio picked using this model has gained 231.3 per cent – or 16.1 per cent per year – making it the best performer of my Guru Strategies (each of which is based on the approach of a different investing great). Over the same period, the S&P 500 has gained just 31.6 per cent, or 3.5 per cent per year.

I also began tracking a 10-stock Fool-based portfolio of Canada-traded stocks almost a year ago, and since then it has put up some exceptional results. Since its Aug. 6 inception, it's up 41.3 per cent, versus 12.7 per cent for the S&P/TSX composite index.

One of the stocks that my Fool-based model is high on right now is Pason Systems, which it gives an 86-per-cent score. The strategy looks for firms with high and stable profit margins; strong momentum (one-year relative strengths of at least 90); sales and profit growth of at least 25 per cent in the most recent quarter (versus the year-ago quarter); and a very low debt/equity ratio. It doesn't have a market cap requirement, but uses several other criteria that guide it toward smaller, less-followed stocks: Annual sales should be less than $500-million; daily dollar volume should be less than $25-million; and share price should be less than $20.

The strategy also takes valuation into account: a stock's PEG or price-earnings-to-growth ratio (that is, its price/earnings ratio divided by its long-term earnings per share growth rate) should be below 0.5.

Pason passes most of the Fool-based model's criteria. Its after-tax profit margins are 14.2 per cent, more than doubling the model's 7-per-cent target; its relative strength is 92; EPS grew by 120 per cent and sales rose 52 per cent in the most recent quarter; and it has no long-term debt. It also has $279-million in annual sales, a daily dollar volume of $1.1-million, and its shares trade for about $14.50.

The Fool-based approach is also high on a number of other Canada-traded stocks right now. While you shouldn't expect it to continue to generate 40-per-cent annual returns, I do think that the strategy will outperform the broader market significantly over the long haul.

The Motley Fool model



Here are a few examples of stocks that meet the criteria of our Motley Fool-based small-stock-oriented model:



Labrador Iron Ore Royalty Corp. : Toronto-based Labrador has a 15.1-per-cent equity interest in Iron Ore Co. of Canada, the country's largest iron ore producer. It operates a mine, concentrator and pellet plant in Labrador City, and is among the top five producers of iron ore pellets in the world. Labrador, which has a market cap of $2.5-billion and $254-million in trailing 12-month sales, gets a 90-per-cent score from my Fool-based model. A few reasons why: Its last quarter was a stellar one, with EPS rising 104 per cent and sales up 82 per cent; it has a relative strength of 93; it has $2.55 in free cash flow per share; and it has a PEG (price-earnings to growth) ratio of 0.48.



Alamos Gold Inc. : Another Toronto-based metals firm, this gold miner has interests in northwest Mexico and Turkey. It has a market cap of about $2.1-billion, and has taken in about $211-million in sales in the past year. Alamos gets an 86-per-cent score from my Fool-based model, thanks to its after-tax profit margins of 34.7 per cent (up from 32.6 per cent the year before and 22.1 per cent two years ago); lack of any long-term debt; and reasonable 0.45 PEG ratio.



Sprott Inc. : This asset management firm has a number of offerings, including hedge funds, mutual funds, and managed accounts, with several focusing on natural resource investments. Based in Toronto, Sprott (market cap $1.5-billion) gets an 81-per-cent score from my Fool-based model. The strategy likes the firm's high and expanding profit margins (29.4 per cent, 31.1 per cent, and 41.7 per cent over the past three years); strong recent growth (EPS rose 75 per cent and sales were up 54 per cent in the most recent quarter); and impressive 0.23 PEG ratio.

 

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