Small wonders
Small cap companies have been some of the market's best performers.
By David Stires, FORTUNE writer

NEW YORK (FORTUNE) - To find profitable and well-managed small caps (companies with market values of $250 million to $2 billion), we followed Chuck Royce's technique of requiring at least an 8 percent return on assets (net income divided by total assets) and positive free cash flow. We screened for stocks with low P/E and price-to-book ratios relative to the Russell 2000 index.

And we considered only companies with stock prices no higher than $35 a share, because they are less likely to be covered by Wall Street analysts and less likely to be heavily owned by institutions, which creates more opportunities for individual investors to get an edge.

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Continuing their strong run, small-cap stocks have risen almost 50 percent since the end of 2000. Our small caps turned in a solid year, delivering a 20 percent average gain.Lincoln Electric (Research) and Arkansas Best (Research) (up 44 percent) did so well that they no longer qualify as small caps, according to our screen.

A new addition is Chattem (Research), which makes niche health-care products, including Selsun Blue shampoo and Pamprin pain reliever. CEO Zan Guerry has pursued a clever strategy of acquiring highly profitable brands abandoned by large consumer product and drug companies. This year Chattem is launching a new appetite suppressant, sunblock, and other products that should give profits a lift in 2007. Yet at 16 times earnings, the stock sells for less than half the multiple of the Russell 2000 small-cap index.

The stocks
  • Small-company stocks (with market caps between $250 million and $2 billion) have been among the market's best performers in recent years.
  • When investing in small caps, look for strong balance sheets--financial strength is crucial for these more fragile firms.
  • Successful small caps can grow into mid-caps and mega-caps ... losers can disappear. So be prepared for volatility.
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Small wonders «click a ticker for latest data»
Company Price
Mkt cap
P/E ratio
on assets
Free cash
Why we like it
Adtran (ADTN) $26 $23-$33 $1,997 20 16% $80 Low-cost telecom-equipment maker is rebounding as carriers upgrade networks.
Chattem (CHTT) $35 $32-$46 $680 16 12% $45 Niche consumer health-care firm with 70% gross margins is rolling out new products.
Emulex (ELX) $18 $16-$23 $1,478 17 10% $76 Scrappy tech firm is seeing increased demand for its computer-networking gear.
Heidrick & Struggles (HSII) $35 $25-$37 $642 16 10% $44 New focus on corporate ethics is sending more clients to this premier search firm.
Helen of Troy (HELE) $19 $16-$26 $581 12 9% $72 Turnaround at this tiny cosmetics company gives stock long-term appeal.
Navigant Consulting (NCI) $21 $17-$24 $1,083 21 10% $38 Consultant is benefiting from litigation and regulatory changes rattling corporations.
Penn Virginia Res. (PVR) $27 $23-$32 $905 20 13% $13 Coal-mining company offers steady growth and a hefty 5.3% dividend yield.
Worthington Ind. (WOR) $18 $16-$21 $1,634 13 10% $134 Uptick in commercial construction market should boost this steel processor's earnings.
Criteria include market capitalizations between $250 million and $2 billion, at least 8% return on assets, positive free cash flow, and share prices no more than $35. *Latest fiscal year