Adventurous investors looking for outsized returns spend a good deal of their time looking for stocks in the small cap space. While smart stock selection can indeed result in significant gains, the risks are also considerable and investors buying small caps, particularly in a market as nervous as the current one, should keep a close eye on their stocks. Understanding, or at least following, the qualitative story is very important, particularly as many of the most promising small caps belong in sectors such as technology and health care where product innovation, regulatory changes and litigation, only to name a few, carry consequences to which smaller companies are more sensitive than bigger ones. While reporting companies’ qualitative story isn’t MarketGrader’s strength, we do believe that beginning your research process with a solid group of well run, profitable candidates can get you off to a good start. Below we list the top five Small Caps in MarketGrader based on a combination of solid fundamentals and strong sentiment. These companies are part of our Small Cap Honor Roll, which you may view here.

DepoMed Inc. (DEPO)

With an overall grade of 93.6 (out of 100), DEPO is the highest graded pharmaceutical company in MarketGarder.com. The company has a market capitalization of $422 million and, it should be said, faces significant headwinds on a number of fronts. Its diabetes drug Glumetza is facing a patent challenge from Sun Pharmaceuticals while its partner, Abbott Labs, has declined to market its new drug Gralise, despite FDA approval. Despite a three month decline of 15% in the price of the stock, most investors seem to be sticking around, as evidenced by our strong Sentiment score of 8.3 (out of 10). MarketGrader’s Sentiment analysis is based on four indicators designed to measure, well, investor sentiment for the stock, irrespective of the company’s fundamentals (RIMM’s Sentiment score, for example, fell from 8.1 in early April to 1.7 in the days before last week’s earnings announcement, which sent the stock tumbling more than 20% in a day).

As indicated by our fundamental grade, DepoMed’s financials are solid, in large part because it posted very strong results for the quarter ended March 31^st. It generated $86.7 million in free cash flow during the last 12 months, on revenues of $149.8 million. The company has been paring its debt load aggressively, with total debt outstanding of just $1.16 million, down 86% from where it stood two years ago. The stock is currently trading at 3.9 times trailing 12-month earnings per share and 4.8 times forward full year earnings. The company’s return on equity in the last 12 months was 85%.

Kulicke and Soffa Industries Inc. (KLIC)

Singapore-based KLIC, which manufactures equipment for the Semiconductor industry, is one of a few highly graded companies by MarketGrader in the sector. It has an overall grade of 93.5, a Sentiment score of 8.6 and a market capitalization of $785 million. The company has cut its debt by 59% in the last two years to $101.75 million, which now accounts for just 21% of total capital. Kulicke and Soffa generated $138.45 million of free cash flow during the last 12 months on revenues of $836.12 million, with a return on equity of 41.3%. Revenues are now 40% higher than they were three years ago. During the last year the company’s margins expanded smartly, with operating margins of 21.17% compared to 8.7% for the 12 months ended a year ago. The stock is currently trading at 4.6 times trailing 12-month earnings per share and 5.7 times fiscal year 2011 estimates.

Republic Bancorp Inc. (RBCAA)

This Kentucky-based bank has a market capitalization of $367 million and the highest overall grade, at 90.3, of all banks in MarketGrader.com. Its Sentiment score is 7.6. RBCAA, which has branches in Kentucky, Indiana, Ohio and Florida, has consistently increased its dividend yearly in the last five years and never had to cut it during the 2008 financial crisis. The bank, which has excellent financials, was highlighted on our Blog last month. During the last 12 months, ended last quarter, Republic Bancorp’s income resulted in a 2.78% return on over $3.6 billion on average quarterly assets, much higher than the average return on assets of 0.05% for all banks followed by MarketGrader. The bank’s capital position is very strong, with core capital accounting for 23.9% of risk-weighted assets, above the 12.7% bank average. Additionally, at the end of last quarter Republic Bancorp had $0.70 in loan loss reserves for every dollar of nonperforming assets. The stock is currently trading at 4.5 times trailing 12-month earnings and 5.4 times full year estimates.

Nova Measuring Instruments Ltd. (NVMI)

Another highly graded company in the semiconductor space, Israel-based NVMI has a MarketGrader overall grade of 90.2 and a Sentiment score of 8.9. It has a market capitalization of $267 million. The company’s revenues and net income have been growing at a healthy clip in recent quarters and it has no debt. It generated $27.38 million in free cash flow on a trailing 12-month basis, on revenues of $98.8 million, which were 72% higher than the 12 months ended three years ago. More importantly, Nova Measuring Instruments has been growing profitably, having grown its gross margin to 57.5% in the last 12 months from 50.6% a year earlier, while achieving a return on equity of 35%. The company’s shares currently trade at 9.3 times trailing earnings and 9 times full year estimates.

Momenta Pharmaceuticals Inc. (MNTA)

Momenta Pharmaceuticals, with a market capitalization of $978 million the highest graded biotechnology stock in MarketGrader.com, is another company investors should monitor closely. We give it an overall grade of 89.5 and a Sentiment score of 8.4. The company was losing money up until three quarters ago, when its growth exploded. Contrast its results for the 12 months ended last quarter to the equivalent period ended a year ago: revenues grew in this one-year period to $191.25 million from $19.95 million; a $62.19 million loss turned into $110.38 million of net income while free cash flow went from a negative $50.1 million to $39.93 million in the most recent period. The company has increased its common share base by 15% also during the last year. It has apparently used its capital and improved operating results to aggressively pay down debt, which went from $11.58 million in 2007 to $1.58 million at the end of the first quarter. It is also sitting on $182 million in cash and other short-term investments. Among things for investors to monitor will be its ongoing profit sharing agreement with Sandoz, part of Novartis, and its pending litigation with TEVA Pharmaceuticals, which Momenta sued for patent infringement last December.

Today MarketGrader is highlighting this small Kentucky-based bank, which has excellent financials  and a pristine record, on Barrons.com. Republic Bancorp (RBCAA) is not only the highest graded bank in all of MarketGrader but the highest graded company in the entire Financial sector and the eighth-ranked stock among our entire coverage universe.

The company has 43 banking centers in Kentucky, Indiana, Florida and Ohio and over $3.6 billion in assets. Its market capitalization is only $385 million. Its trailing 12 month revenue, at the end of the first quarter, was $314 million with $91.5 million in net income. Its first quarter results were remarkable, with revenue increasing 22% year-over-year to $180 million and net income jumping by 60%. The bank has beaten the consensus estimate of the two analysts that follow it by an average of 21% in the last six quarters.

The stock trades at 4.7 times trailing 12 month earnings per share, virtually the same ratio when compared to its full fiscal year estimates (forward P/E). And following today’s across-the-board market drop, at its closing price of $20.17, the stock can be bought for less than the $20.50 in tangible equity per share. Buyers at this price will essentially get the bank’s dividend and its future earnings stream for free.

Republic Bancorp’s grades are very strong not only across our Growth and Value indicators but also according to our Profitability and Cash Flow measures, which explains its overall remarkable grade of 90. The stock’s Sentiment, by the way, is also positive, with a score of 7.7 out of 10. From a profitability standpoint, the bank’s net interest margin is the equivalent of 8.9% of its interest earning assets, compared to 3.6% on average for all public banks followed by MarketGrader and based on trailing 12 month results the bank’s return on equity was 21% while it returned 2.8% on assets that averaged $3.3 billion in the last four quarters. The average ROA of all banks in our system was 0.3% during the same period.

Republic Bancorp’s capital position couldn’t be stronger. It reported Tier 1 (core) Capital of 23.9% last quarter compared to the bank average of 12.7%. Its non-performing assets fell in the last year to 9% of tangible equity from 12.4% a year ago. Again, for comparison purposes, non-performing assets for all banks followed by MarketGrader average 73% of tangible equity plus loss reserves, underscoring the difficulties banks are having working through the bad assets they piled onto their balance sheets during the recent free credit mania. RBCAA today has $0.70 in loss reserves for every dollar in non-performing assets, as solid as a bank gets. Underlying all of this, the bank’s stockholder’s equity is very clean, with intangible assets representing only 2.3% of common equity.

To top it all off, the bank increased its dividend, as it usually does, at the end of 2010, and it now pays $0.15 per share, yielding almost 3% at today’s stock price. Two things are remarkable and worth mentioning about its dividend: first, dividends paid in the last 12 months accounted only for 7.5% of cash flow and 12.7% of after-tax earnings, giving it plenty of room to increase it, although given management’s apparently conservative style, large special dividends are unlikely. And second, the bank never had to cut its dividend during the financial crisis like so many others did. Banks looking for acquisition targets with a decent presence in the south could do worse than look at RBCAA.

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