In response to a subscriber question, Editor-in-Chief Doug Gerlach describes another tool that can be used to find small-cap stocks of interest.

Subscriber Frank T. writes the SmallCap Informer to ask: “I like the idea of investing in smaller companies, and have found some interesting ideas in the first few issues of your newsletter. But I would like to learn more about finding small-company stocks on my own. How do you find the companies that you are presenting? Do you have any tips for me to find other similar stocks for my portfolio?”

A stock screening tool is an essential part of any investor’s toolbox. ICLUBcentral, publisher of the SmallCap Informer, has long offered Stock Prospector for Windows, a desktop screening tool directed at long-term investors that helps to discover stocks meeting specific criteria such as rate of earnings per share growth, relative value, or pre-tax profit margin trends.

Recently, ICLUBcentral upgraded the tool to an all-online subscription version:  MyStockProspector.com. Accessible from any Web browser, MyStockProspector.com uses 10-year company histories (courtesy of Morningstar, the same data used on our StockCentral website and by BetterInvesting in its stock analysis tools) and offers more than 120 different criteria to help investors to pinpoint stocks that meet their personal criteria.

Among the criteria available for searches are the most recent annual sales and the market capitalizations of companies. This allows you to target smaller companies in your screens, as we do when we sit down to find potential candidates for the Informer.

Without giving away our “secret sauce” for finding companies of interest, here are some of my thoughts and tips for building a stock screen using MyStockProspector.

In my 2004 book, the BetterInvesting Guide to Computerized Investing and the Internet, I outlined a sample small-company growth screen, and the criteria are still valid today.

Sales greater than $500 million.  This limits your search to companies that have revenues in the last 12 months less than $500 million, the definition of a “small” company proposed by BetterInvesting.

EPS and revenue growth in past three years greater than 15 percent. Smaller companies can’t be expected to have a full 10 years of history, so looking for companies with high growth in the past three years can find those with acceptable growth.

EPS R2 in past three years greater than 0.75. R2 (“R-squared”) is a measure of the consistency of a series of points, so this figure looks for companies with a certain minimal level of consistency of growth.

Debt/equity ratio less than 50%. Companies that are laden with debt may be less likely to perform well during economic hard times, so limiting the maximum amount of debt lessens the potential of this problem. To tighten up this area, set the limit at 33% or even to zero.

Pre-tax profit margins are stable or increasing. Stock Prospector and MyStockProspector.com use a unique numerical rating system that evaluates a company’s pre-tax margin trends (thus allowing you to limit your results to companies that look good in Section 2 of the Stock Selection Guide). In the program, set the PTI rating to be greater than 2.

Now, view your results. You should have plenty of companies to study. If you have too many companies, then you can consider adding some additional criteria, such as:

Stable or increasing return on invested capital. Similar to the PTP Rating described above, set the ROE rating to be greater than 2.

Insider ownership > 15%. This means management’s interest is aligned with shareholders.

Institutional ownership > 10%. Some institutional interest is desirable in order to support share price growth.

You’ll note that there are no valuation metrics included in the above criteria. My preference is to search first for quality companies, then review their valuations independently. If you wish to screen a bit deeper, however, here are some valuation criteria that you could include:

PEG ratio between 0.75 and 1.2.

Relative value between 0.75 and 1.2.

These won’t eliminate overvalued stocks completely, but they will isolate companies that may be closer to an attractive current buy price.

  — DOUGLAS GERLACH