Investing in smaller companies can offer individual investors many important advantages. Perhaps the most important of all is that these companies can grow very quickly, since it doesn’t take much for new sales and profits to make a big impact on overall growth. Many stocks with small market capitalizations also fly under the radar of Wall Street. And because Wall Street mainly focuses on serving large institutions and other big-money investors who have billions of dollars to invest, small-cap investors have a higher likelihood of uncovering unique, profitable investment opportunities.

Accessibility is another important benefit. Because they know they likely won’t attract the attention of the larger investment houses until they’re a proven commodity, small companies are more willing communicate with smaller investors.

I recently attended the East Coast Ideas conference in Boston,  which caters to smaller and mid-size companies. I had the opportunity to sit down with a number of executives of various exciting companies, hear their investment story and ask a number of questions. Three companies in particular stood out to me as worthy candidates for a small-cap watch list.

1. Computer Task Group
Business: Digital Health Care and IT Staffing
Market Capitalization: $174 million
P/E: 16

Computer Task Group (Nasdaq: CTGX), or CTG for short, operates two business units. The first provides information technology (IT) staffing for clients, be it for short-term projects or  permanent positions. This business unit accounted for 66% of total sales last year. It’s a steady and somewhat profitable business (operating margins were 3% last year). However, management is turning its attention to the other division, which provides IT solutions in health care, including the rapidly evolving market for digital medical records.

[CTG’s foray into digital medical records isn’t surprising. My friend Andy Obermueller thinks it’s a bona fide game-changing opportunity for the medical industry — and shareholders of companies that facilitate the transition.]

This segment offers much faster growth potential and operating margins closer to 10%. CTG is also one of the top three providers of e-medical record solutions for hospitals and health care providers. Affiliated Computer Services, which was acquired by Xerox (NYSE: XRX) in August 2009, and accounting and consulting firm Deloitte, are the other two. Despite the strong competition, CTG has become IBM’s (NYSE: IBM) preferred provider of health care solutions and related work. In fact, IBM accounted for 30% of CTG’s total sales last year alone.

In the past five years, CTG has improved annual sales by about 11% and projects an annual profit increase close to 20% for the three-year period ending in 2011. The one analyst who follows CTG predicts earnings per share of $0.72 and sales growth of nearly 18% to almost $400 million this year. With a reasonable price to earnings (P/E) ratio, the exposure to a fast-growing market and good chances to boost total company profit margins and overall growth, CTG is an extremely interesting small-cap play.

2. A.T. Cross Group
Business: Cross Pens and Sunglass Brands
Market Capitalization: $153 million
P/E: 21

Like CTG, A.T. Cross Co. (NYSE: ATX) operates two businesses. The older unit is the Cross Accessory Division, which sells things like ball-point pens, fountain pens, mechanical pencils and desk sets. This is the slower-growing part of the business, although it does generate steady profits. Management projects this division will sell $97 million, representing 56% of the company’s total sales in 2011.

The other segment, the Cross Optical Group, consists of two premium sport/performance sunglass brands. The first, Costa, caters to outdoor enthusiasts — the fishing crowd in particular. (It also helps that country music star Kenny Chesney wears the brand.) The second sunglass brand is Native, which is billed as an outdoor brand that caters to individuals who bike, climb and run. Management projects sales of $70 million within the division this year and up to $100 million within three years.

Again, only a single analyst covers A.T. Cross Co., but management has offered full-year earnings guidance between $0.56 and $0.60 per share. This puts the forward P/E at more than 20, which is a bit high, but could prove quite reasonable given the rapid growth potential of the sunglass brands.  

3. Comfort Systems
Business: HVAC Installation and Services
Market Capitalization: $385 million
P/E: 10 (on a normalized basis)

This value play is interesting for its recovery potential.

Comfort Systems (NYSE: FIX) installs HVAC heating and cooling systems for businesses, factories and other commercial clients. Sales were hit by nearly 20% because of the financial crisis, so it has relied on acquisitions to bolster sales, which are just above $1.1 billion — slightly ahead of where they were in 2007. But the company remains profitable, showing a healthy order backlog in excess of $600 million.

Management projects more merger and acquisition activities ahead, thanks to the company’s relatively strong position in a very fragmented industry. This could boost total sales, but Comfort Systems will need a sustainable recovery in construction and industrial activity in the United States before it’s able to see a solid turnaround. In the meantime, the best it can do is focus on increasing productivity and trying to gain market share. (Comfort is still a relatively small player the $40 billion HVAC market.

Five analysts currently follow Comfort Systems, which still is a small amount. They collectively project 10% sales growth for 2011 and total sales of $1.2 billion. They only expect $0.14 in per-share earnings, but see a quick recovery to $0.51 in 2012. Within a couple of years, the company should be able to again report earnings above $1 per share, as it did in 2008 The stock could also recover closer to $15 a share, or 50% above current levels.

Action to Take –> CTG is already a leader in the growing market for digital medical records. Its relationship with IBM should allow it to grow rapidly in the coming years. A.T. Cross has very compelling growth potential because of the popularity of its sunglass brands, which still have yet to fully expand out of its core Southeast market into the rest of the country, much less internationally. Finally, Comfort Systems is more of a wild card, but it has solid recovery potential within the next two to three years. All in all, these three small-cap stocks are worth buying for their solid 30–50% upside potential.

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