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3 Small-Cap Gems to Winterize Your Portfolio

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Winter is coming. As a fund manager, I could hardly be more excited about this. Later this week I’ll dig into all the reasons why we are entering what is truly the happiest time of year for the stock market (especially small- and mid-caps), but I want to get this bulletin out immediately. That’s because today I’m going to introduce what I consider to be three of the best small- and mid-cap stocks on the market right now.

What To Watch Out For

But first, a word of caution. I will be the first to admit that there is a lot of “froth” in this market. A textbook case of this is Tesla Motors (TSLA), since the company is grossly overvalued relative to its sales and underlying earnings.

Just take a look at its Portfolio Grader rankings. You’ll see that while TSLA is an A-rated stock right now, that’s only because of its Quantitative Grade, which indicates the current level of institutional buying pressure. What happened was when Tesla got added to the NASDAQ 100 to replace Oracle (ORCL), the company benefitted from increased buying pressure from managers looking to replicate the index’s performance. This help explains why the company now has a market capitalization in excess of $20 billion, which is over 10 times its annual sales pace and well over 400 times its forecasted earnings!

While I always like to see a healthy Quantitative Grade, in the small- and mid-cap arena it’s essential that a stock is also backed up by healthy fundamentals. That’s where TLSA falls short, with a C-rated Fundamental Grade. Of the eight fundamental metrics I graded this stock on, it scored well on just two metrics—sales growth and earnings momentum. Meanwhile, it squeaked by with Cs on four metrics (including operating margin and earnings growth), and it outright failed on cash flow and return on equity. So while TSLA is an A today, slight changes in buying pressure could send this stock down to a C-rating (or lower) easily.

The case with Tesla shows that there are some valuation problems brewing as multi-billion dollar Wall Street ETF machines continue to buy stocks, regardless of valuations. But I want to stress that this “froth” does not exist for all small- and mid-cap stocks. In fact, there are some unprecedented buying opportunities to be had before the market realizes where the quality truly lies.

Speaking of which, I have my eye on these three stocks:

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