We don’t officially hit the spring season until tomorrow, but investors appear to be dragging the market out of the winter doldrums in advance of the solstice. 

Newly invigorated at last, they’ve given the market a new lease of life that has sent the S&P 500 up more than 20% from its lows. 

If this bout of fresh buying triggers a domino effect, more investors might be tempted to follow suit. And while I don’t wish to rain on the current mini-parade, keep in mind that the relatively placid stream we’re seeing now could become a Class 5 river, complete with roaring rapids, all over again. 

But despite the treacherous waters, there are still ways to negotiate them safely. Here’s how to do it…

Small Caps –  Leading The Market Out Of Downturns

History has shown that there’s one category of stocks that recover from economic downturns and bear markets faster than most others – and lead the way forward towards recovery. 

Small caps. 

But in this environment, not only do I prefer small-cap stocks for this reason, but also because many of these companies are still under the radar. That gives savvy investors the chance to get in before Wall Street discovers them. 

The trick is to identify the right ones. After all, there are often very valid reasons why Wall Street doesn’t pounce. 

2 Key Elements For Finding Small Caps 

Right off the bat, here are two important features I look for when picking stocks: 

• Call me old-fashioned… but I still believe in earnings growth. And when a company is generating it, there’s little argument about whether it’s got a good, successful business.
   
• Next, I look to the bank balance. I always like to see businesses that have enough cash available to fund operations and continue growth themselves, rather than needing to raise a ton of capital to do it. 

So with that agenda, I screened the 7,000 or so companies with a market cap of $1 billion or less. I then drilled down further and looked for companies with… 

• More cash than liabilities
• An expanding operating margin
• Increasing cash flow from operations
• A 5-year expected annual earnings growth rate of 20% or more
   

3 Small Caps with the Potential For Explosive Growth

I settled on three small cap companies – all of which are in different sectors – that boast plenty of cash and the potential to generate explosive growth over the next few years. And here they are… 

~ Gmarket (Nasdaq: GMKT) is the eBay (Nasdaq: EBAY) of South Korea. Although eBay has a presence in the country, Gmarket seems to have a better understanding of its users – and naturally, a better relationship with them because of that. 

Gmarket also has $230 million in cash and no debt. And at less than 7 times free cash flow and 18.5 times earnings, the valuation seems reasonable, given that earnings growth over the next five years is expected to roll in at 35% annually. Not to mention that in 2008, operating margin grew sharply from 11.9% to 16.6%. 

Currently, Yahoo! (Nasdaq: YHOO) owns 10% of Gmarket, but I wouldn’t be surprised to see eBay acquire it in order to capture that growing cascade of free cash flow.

~ American Public Education (Nasdaq: APEI) provides online education services to the military and public service communities. In a faltering economy, many people go back to school to try to beef up their resume and improve their skills, so APEI should benefit from that trend. 

The company has $47 million in cash and no debt, which makes it perfect for any portfolio. The only catch is that it’s not cheap, trading at 35 times projected 2009 earnings. Normally, that’s a rich valuation but when the 5-year annual growth rate is projected to be 39%, 35 times earnings starts to sound like a bargain. 

If you need a little further incentive, consider that operating margin climbed to 23.3% in 2008 from 21.3% the year before. And cash flow from operations and free cash flow both grew significantly in 2008. 

~ CardioNet (Nasdaq: BEAT) has been on fire since late 2008, thanks to its Mobile Cardiac Outpatient Telemetry (MCOT) device – a wireless system that tracks heart rhythm data and transmits the information back to a monitoring center. 

Americans aren’t getting any younger – or healthier – and that means the number of heart disease-induced health problems will continue to rise. In fact, the numbers are already great enough to make it a $2 billion market – one in which CardioNet is already actively involved. 

The company has $58 million in the bank and less than $1 million in long-term debt. Earnings per share in 2009 are projected to come in $0.71, but that figure is expected to nearly double to $1.36 next year alone. 

Like American Public Education, CardioNet has a high multiple, trading at 37 times estimated earnings. That’s a little on the pricey side, but still well worth it, thanks to a 42% projected annual 5-year earnings growth rate.

And to sweeten the deal further, margins are improving and the company posted positive cash flow from operations for the first time in 2008. 

The bottom line is that in a market like this, you need to look for small cap stocks built not only to handle the rough seas, but which will continue to thrive well after we’re through this rough spot. 

And by nailing down small cap companies that are growing their earnings and have plenty of cash in the bank, it’s an excellent place to start.

Marc Lichtenfeld
Smart Profits Report