Small companies typically outperform over time because they have greater growth prospects than the market leaders.
Between 1927 and 2012, for instance, small caps produced annual returns of 12.9%, compared with 9.9% for large companies. Even now, when many indices have hit highs, the S&P 600 Small Cap Index has gained 31%, in the past year compared with a 23% gain for the S&P 500 over the same period.
So to find small-cap stocks that could be assumed to be reasonably safe investments, I used a several-step screening process, starting with solid fundamentals and substantial insider and institutional ownership.
Among companies with market caps of no more than $90 million, I found 23 that had positive returns on equity and assets, a forward price-to-earnings (P/E) ratio, and institutional and insider ownership of at least 10%.
*of those with dividends
I compared the one-year returns of these stocks with the S&P 600 Small Cap Index. Any stock that had crossed below the index and was trending down was dropped, which left me with six contenders -- three of which paid dividends. Like many investors, I have a bias toward stocks that pay dividends, so let's look at those.
What I found were three companies which each have been on a solid growth trajectory.
Acme United (NYSE: ACU) is a global supplier of cutting, measuring and safety products to consumer and industrial markets. It has neatly tracked the S&P small-cap index and shown the least volatility of the three stocks. While its $43.7 million market cap is the lowest of the three, its nearly $14 share price is the highest. It has a forward P/E of 9.2, and its dividend yield is the best of the three at 2.3%. In its most recent quarter, Acme posted a 7% increase in net income and a 3% rise in earnings.
On the institutional side, North Star Investment holds nearly 400,000 shares and has made more than a dozen insider purchases this year. Acme's CEO, Walter Johnson, did sell 8,000 shares this month, but he still holds more than 350,000 shares.
Eastern Virginia Bankshares (Nasdaq: EVBS) is a bank holding company. It received $24 million in financial bailout funds, but it's been released from its agreement with regulators because it raised enough money through private placement. Its $66.7 million market cap puts it in the middle of the group, although its share price is currently the lowest at just over $6. It has a forward P/E of 9.2, but its 1.1% dividend yield is the least of the three. Net income and earnings were down for the most recent quarter, mainly on charge-offs for non-performing and uncollectible assets and other losses.
EVBS' management and directors have been on a spree buying back stock this year, including 19 transactions in June alone at $4.55 a share -- nicely timed before the company said it had been released from its Troubled Asset Relief Program (TARP).
Pzena Investment Management (NYSE: PZN) is an investment manager catering to wealthy families and other institutions. It has the largest market cap at $85.4 million, and its share price, although the highest at about $7, buys the most market cap per dollar of the three. It has a forward P/E of 14 and a dividend yield of 1.7%. For the most recent quarter, revenue grew 5.4% and earnings were flat. Although Pzena's gross profit margin was down from the previous year, it remains a very high 45.2%.
Top holders include Fine Capital, with nearly a quarter of a million shares, and Renaissance Technologies, with about 125,000 shares. Renaissance's bet on PZN is interesting because it usually is heavily invested in large caps.
Risks to consider: Neither past performance nor insider or institutional investment is a guarantee of future success.
Action to Take --> Together, these three stocks are quite promising. Due to the heavier institutional investment, I give PZN a slight edge over ACU. EVBS still has a way to go to prove itself, but now that it's free of the bailout program, it could really blossom.