The Quest For Top-Quality Small Stocks

Investing in top-quality small stocks will reap more significant profits and avoid more pitfalls. Keep on top of these criteria by reading the stock’s quarterly and annual 10-K reports, typically available on the company’s website. Research the company online by visiting third-party platforms like MarketWatch, Seeking Alpha, The Motley Fool, and Yahoo Finance, just to name a few.

Using these guidelines, your chosen stocks are entirely up to you. Some stocks will perform exceptionally well, while others may not. However, investing in individual top-quality small stocks makes you want to push the odds as much in your favor.

Choosing Top-Quality Small Stocks

Guideline #1

Rising earning growth for at least ten years. Or for as long as the stock has been publicly traded.

Rising earnings are what propel a small-growth stock upward. Stocks with little or no earnings are an unknown quantity. They could be wildly profitable if their promise translates into rising profits. But there’s nothing to cushion their fall if those expectations are empty. Generally, the best stocks are those with long-term profit growth rates of at least 10%.

Guideline #2

Rock-solid balance sheet.

Bond ratings from Moody’s or Standard & Poor’s are probably the best ways to gauge a company’s financial strength. Ratings of BBB (Baa2 for Moody’s) or higher are preferable. However, because many small companies have not issued bonds or are unrated, that may not be an option. For these companies, the best measure of a firm’s financial health is how much debt it has, particularly relative to its “shareholders equity.” Lower debt (20% or less of total capital) means the company can cut costs during an economic downturn. Higher-debt firms can be forced to curtain expansion plans dramatically should sales growth slow unexpectedly.

Guideline #3

Free cash flow.

The company should have money left over after paying all its expenses, including interest on loans and construction costs. This money is called “free cash flow.” It can be used for stock repurchases, dividend boosts, expansion, buying out other companies, or to beef up the company’s investments. In all cases, shareholders benefit.

Guideline #4

Rising operating margins that are at least within a percentage point or two of all-time highs.

This is the gross profit from a company’s operations, the best measure of how profitable a company is. A rising margin indicates that the company has secured a thriving niche market, where its dominance will produce big profits in the years ahead. It’s calculated by dividing a company’s total revenue by total operating expenses (excluding debt repayments).

Guideline #5

Relatively low P/E ratio.

The price-to-earnings ratio, or P/E, is a way to value a company by comparing the price of a stock to its earnings. The P/E equals the price of a share of stock divided by the company’s earnings per share. It tells you how much you are paying for each dollar of earnings. A stock with high growth potential and a low P/E is indeed a rare find. Specifically, you want to find a company whose annual earnings growth for the past five years is 50% lower than their P/Es. In other words, if a company has a five-year profit growth rate of 10% and a P/E of 30, it’s not acceptable. However, it would be acceptable if its earnings growth rate were 20%.

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