Small-cap firepower

Is your portfolio almost entirely in large-capitalization stocks such as General Electric Co., Walmart Stores Inc. and Microsoft Corp.?

If so, you may be missing something.

I have nothing against big, relatively stable companies with a proven history of earnings power. But large often means mature. The chances of Pfizer Inc. or Procter & Gamble Co. appreciating 500 percent over the next decade seem remote.

Outsized gains are more typically found among small-cap stocks, which are less covered and often undiscovered. Small stocks have more room to grow.

Perhaps that is why the Russell 2000 Index, a small-stock gauge, recorded a 44 percent total return over the 10 years ending March 31, 2010, while the Standard & Poor’s 500 Index, a measure of large stocks, fell 6 percent, including reinvested dividends.

Here are five small-cap stocks to consider. They have a market value of $100 million to $1 billion and are listed in size order, smallest first.

Mercer Insurance Group Inc., in Pennington, N.J., sells property and casualty insurance, mostly to small- and medium-size businesses. Its market cap is $117 million.

This little insurance company, which traces its roots to 1844, began trading publicly in 2003 and has earned a profit ever since. Each year except 2008, profits have risen. Given the recessionary storms that raged that year, I think most investors can forgive the one-year lapse.

The stock is valued in exactly the way that warms my cheapskate heart. It sells for nine times earnings, 0.8 times book value (corporate net worth) and 0.7 times revenue.

Barely bigger is VSE Corp., a defense contractor based in Alexandria, Va. Its market cap is about $200 million.

Just recently, VSE announced that it had won a contract worth $42 million over five years for decontamination and demolition support at the Naval Surface Warfare Center in Indian Head, Md.

In each of the past two years, VSE has racked up revenue of a little more than $1 billion. The company earned $19 million in 2008 and $24 million in 2009. VSE is riding a seven-year streak of increasing earnings. During that stretch, earnings have risen by 24 percent or more every year.

The stock traded above $61 a share in October 2007, around the time the U.S. stock market peaked. Lately it sells for about $38, a victim of the recession and expired contracts. Valued at about 0.2 times revenue and eight times earnings, VSE has my kind of multiples.

From Bentonville, Ark., home of Walmart, comes America’s Car-Mart Inc., a chain of used-car dealerships. You can bet your carburetor that selling used cars is unglamorous, but I believe now-frugal Americans will have above-average interest in them for the next few years. The company’s balance sheet is strong, with debt less than 20 percent of stockholders’ equity.

The company has been consistently profitable, showing positive annual earnings since 2003. Profits have shown a rising trend in five of the past seven years.

At about 12 times earnings and less than one times revenue, Car-Mart’s stock price won’t induce sticker shock. The market cap is $275 million.

Gulf Island Fabrication Inc., based in Houma, La., builds offshore oil-drilling platforms and makes components for them. The company has a market value of about $294 million.

Gulf Island’s profits vary a lot from year to year, but it has stayed in the black since 1995. It went public in 1997.

I have written here before that much of our oil will have to come from offshore, not onshore, wells. The recent decision by President Barack Obama to open additional areas to offshore drilling reinforces the point.

Shares are trading for about 14 times earnings and one times revenue. The company is debt-free.

Moving from the oil patch to the plains of the Midwest, I recommend FBL Financial Group Inc. of West Des Moines. It sells life insurance, annuities and mutual funds to farmers, ranchers and other customers in rural areas.

FBL does most of its business through two operating companies, Farm Bureau Life Insurance Co. and EquiTrust Life Insurance Co.

FBL’s market cap is about $814 million. The stock is attractively cheap in my view, selling for nine times earnings, 0.9 times book value and 0.7 times revenue.

Large-cap and small-cap stocks tend to take turns outperforming each other. Generally in times of uncertainty and stress, investors return to the safety of large-caps. When they are more optimistic, they want the added appreciation potential of small-caps.

In the past 30 years, small stocks have topped their bigger brethren 19 times while large-caps have led 11 times.

It’s tempting to think that one can guess in advance which one will outperform in a given year, but in practice it is difficult. The wisest course, in my view, is always to have small-cap representation in a portfolio.

Disclosure note: I have no positions in the stocks discussed his week.

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