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number cruncher

What are we looking for?

U.S. small caps with good profits boosting both top and bottom lines.

The screen

For the retail investor, investing in small-cap companies holds two particular concerns. Firstly, small-cap companies tend not to be as widely covered by sell-side analysts as larger names, precluding the ability to use estimates as a gauge for future performance of the company. Secondly, small-cap names can be illiquid, leaving uncertainty on entry and exit points. However, small caps can also be great alpha generators because of the very fact that they are not widely known. Also, retail investors not moving large amounts of capital might find it easier to execute without affecting the market price (compared with a large institution). This week, I used Morningstar CPMS to create a strategy from the S&P600 small-cap universe. The strategy ranks stocks on the best combination of:

  • Five-year sales growth (percentage that top-line revenue has grown over the past five years)
  • Five-year EPS growth (percentage that bottom-line EPS has grown over the past five years)
  • Variability of earnings over the past five years (lower numbers are preferred here, signifying that reported earnings are consistent)
  • The latest reported ROE and the average ROE over the past three- and five-year periods

To qualify, companies must have a debt-to-equity ratio that is less than the median of the sector to which it belongs.

More about Morningstar

Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.

What we found

I used CPMS to back-test the strategy from December, 1998, to July, 2016. During this process, 10 stocks were purchased and equally weighted with a maximum of three stocks a sector. Stocks would be sold if they fell outside the top 30 per cent of the ranked universe, or if the stocks' price dropped by more than 15 per cent over one month. Over this period, the strategy produced an annualized total return of 14.8 per cent, while the S&P 600 total return index produced 8.5 per cent. The 10 stocks that qualify today are listed in the table above.

As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.

Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.

U.S. stocks with positive top and bottom lines

RankCompanyTickerMarket Cap (US$ Mill.)5Y EPS Growth (%)5Y Sales Growth (%)5Y EPS variabilityLatest Reported ROE3Y Ave. ROE5Y Ave. ROED/E Relative to Sector MedianYield (%)
1Blue Nile, Inc.NILE-Q355.934.0614.6912.7676.8663.350.120.050
2Cal-Maine Foods, Inc.CALM-Q2040.990.3116.1941.637.6727.4522.020.015.17
3Sturm Ruger & Co Inc.RGR-N1259.126.7111.8132.7532.6245.1943.5102.95
4AAON Inc.AAON-Q1443.2927.458.37.952723.8721.0700.81
5Drew Industries Inc.DW-N2343.926.3816.618.3124.4317.5915.320.151.25
6Medifast Inc.MED-N423.76.081.316.324.5623.9725.2802.8
7SciClone Pharmaceuticals Inc.SCLN-Q519.5511.155.4726.523.318.9720.7800
8Apogee Enterprises Inc.APOG-Q1349.9759.8710.2313.2817.3711.417.980.071.07
9Cantel Medical Corp.CMN-N2992.5421.9413.023.3214.3613.3512.50.560.17
10Standex International Corp.SXI-N1143.7110.834.673.1916.1816.5516.760.460.63

Source: Morningstar Research Inc.