Regular readers of my articles know that I spend most of my time in search of undervalued mid-sized and large companies. There are so many bargains in the S&P 500 alone, that it simply hasn’t paid to spend too much time on small — and risky — stocks in recent quarters.

Yet every portfolio needs a broad cross-section of holdings if it is to beat the market. This means you should hold a basket of micro-cap and small-cap stocks alongside your blue-chip holdings. To mitigate the risk that these small companies stumble badly, it pays to get a vote of confidence that business is solid. These smaller companies, all trading below $4, have all seen such a vote of confidence in the form of notable levels of insider buying.

1. Harris & Harris (Nasdaq: TINY)
Recent price: $3.84
This investment firm takes stakes in a wide range of privately-held technology companies that cater to the biotech and industrial sectors. The portfolio companies often seek to commercialize nanotechnologies, which are processes that yield miniaturized lubricants, materials and other industrial goods.

The market rout of last summer was hard on this speculative stock, as its shares fell from $5.50 to below $4. They’ve stayed out of favor ever since. In fact, shares stood at $25 a decade ago.

Investors are clearly shunning hard-to-value stocks like this one. In response, management has been conducting an increasing number of “liquidity-inducing events,” by which some or all of the holding is sold off. Harris & Harris had five such events in 2011 (after zero in 2010), and recent management comments imply plans for five or six portfolio sales in 2012 as well.

The value of Harris & Harris’ holdings equal $4.38 a share, meaning you can own the basket of companies at a 12% discount to the current stock price. With shares below $4, nearly a dozen insiders have acquired a combined 31,000 shares since the middle of November, worth more than $100,000.

2. Denny’s (Nasdaq: DENN)
Recent price: $3.94
Insiders have also been acquiring shares of this quick-service restaurant operator, highlighted by roughly $500,000 in stock purchases by company President John Miller in December. Denny’s insiders have been quite bullish for awhile, as I noted last summer.
 
Shares swooned in the summer rout after I wrote about the stock, but shares have steadily rebounded in recent months back to the $4 mark. This stock may make a move on $5 or even $6 in 2012. That’s because same-store sales remain positive, debt is falling and the share count keeps shrinking. Those are the typical ingredients of a turnaround.

The debt pay down and share buyback is coming from healthy EBITDA, which likely hit around $78-79 million in 2011, and could approach $85 million in 2012. (Management will lay out 2012 financial targets on Feb.15.) The appeal is in this stock is that Denny’s has taken a series of tough steps in a bad economy (such as reducing costs wherever possible), which should really pay off when the economy turns up.

3. Primo Water (Nasdaq: PRMW)
Recent price: $2.75
This stock muddled along in the low teens until it posted a surprise second-quarter loss in late July. The stock lost more than half of its value and then staged a decent rebounded during the next few months as management announced plans to augment its traditional water distribution business (mostly to offices) with a carbonation drink-making machine, similar to one offered by Sodastream (Nasdaq: SODA).

But another weak quarter, led by a slower-than-expected rollout of that carbonated water initiative sent shares to new lows, where they sit today. Insiders began buying back in mid-August in the $4.50 to $5 range. But they should have saved their money. In December, they made a savvier move, picking up around 300,000 shares at a little less than $3. Even that buy is now underwater, but those most recent trades may pay finally pay off as the business finally starts to move back into profitability. Analysts spy an inflection point in the March quarter and rising profits from there, as rising sales leverage a fixed cost base.

Taking a look at recent quarterly results, it appears the company moved too quickly to get its traditional and carbonated water machines into many new offices. Management appears committed to letting revenue catch up with the distribution infrastructure put in place. I’d suggest listening to fourth-quarter results in mid-February to get a clearer read on the type of profitability this business model can generate.

Risks to Consider: Smaller company stocks would be the first to take a hit if the European crisis deepens.

Action to Take –> As I recently noted, small-cap stocks actually make solid investments — if the economy has turned the corner.

Insider activity at these companies implies a bullish outlook for 2012. Denny’s appears to be the most stable of the group, but with perhaps with 30% to 40% upside at best for 2012. Harris & Harris looks quite oversold and should rally when growth-investing is back in favor, whenever that era returns. Primo Water has been performing poorly in recent quarters, but has the makings of a solid turnaround.

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