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Stock Strategist

Three Small-Cap Stocks for a Slugger's Portfolio

We've found a few more picks with home-run potential.

A few months ago, we took a look at a few small-cap stock ideas for your portfolio in our article, "Bat Like Babe Ruth." We contended that swatting a few home runs in your portfolio could have a greater impact on your performance than your batting average, and we culled the universe of stocks with market capitalizations under $2 billion to find potential home-run hitting ideas.

On Feb. 28, we highlighted  James River Coal ,  Angiotech Pharmaceuticals , and  Cheniere Energy (LNG) as three stocks that we thought had home run potential. Two of these three stocks have produced spectacular performance since then, with James River and Cheniere rising 64.6% and 21.8%, respectively, through May 9. The third stock, Angiotech, increased just 0.9% over that period. Overall, this equates to a total shareholder return of 29.1%, easily outperforming the Russell 2000 and the S&P 500, which finished up 5.6% and 8.5%, respectively.

However, it is important to note that we are looking back on a very short time horizon of just over two months. Small-cap stocks tend to be volatile, and we wouldn't be surprised to see significant fluctuations in the prices of these stocks. We could still end up striking out with one or more of these stocks (our first three recommendations all have above average risk ratings), but a substantial rise in just one could very well lead to superior investment returns. We continue to see further upside in all three stocks, but would note that Cheniere is now trading above our "Consider Buying" price.

With that in mind, we'd like to offer up a few more small-cap ideas that could also turn out to be home runs. In contrast to the above-average risk of the stocks we mentioned last time, these three investment ideas are considered average risk, so we require a smaller discount to our fair value estimate before we would consider investing in them.

 Radware (RDWR)
Business Risk: Average
Economic Moat: None
Price/Fair Value Ratio*: 0.63
Consider Buying: $15.40 or below
Consider Selling: $25.10 or above

Despite its focus on providing hardware and software for application switching, a hot area in the networking industry, Radware has suffered from a number of problems with its U.S. salesforce that have prevented it from taking part in the industry's growth. However, we think these problems have brought the stock down to a level where the potential reward from investing in this Israeli-based technology firm outweighs the risk that the firm will not get its salesforce in order.

Radware has recently hired an industry veteran to help get its North American salesforce back on track, which analyst John Slack thinks could result in an eventual return to growth. Further, the company has more than $8 per share in cash. As Slack notes, "net of this cash position, the company is trading at less than 2007 sales given its current share price, a rare value, in our opinion, in one of the more attractive niches of the networking equipment industry."
Full Analyst Report:  Radware

 Ruth's Chris Steak House (RUTH)
Business Risk: Average
Economic Moat: None
Price/Fair Value Ratio*: 0.66
Consider Buying: $21.60 or below
Consider Selling: $35.10 or above

With more than 100 restaurants worldwide, Ruth's Chris has one of the strongest brands in the fast-growing fine dining segment. The company leverages its size and coast-to-coast footprint with national advertising, complemented by targeted local media, which helped to boost its average unit volume to $5.7 million last year. Analyst John Owens thinks that with attractive unit economics and an in-house development team, Ruth's Chris could ultimately expand to 250 domestic restaurants. He notes that the chain has been successful in markets as large as Manhattan and as small as Lafayette, La.

This investment, however, is not without risks, including volatile beef prices. Management also could become too focused on rapid expansion, and its high standards, so essential to success in fine dining, could begin to slip. Other upscale steakhouse chains, including Morton's and Fleming's, are accelerating their pace of expansion as well, so rivalry will likely intensify. Still, the risk/reward balance looks quite attractive here.
Full Analyst Report:  Ruth's Chris

 BankAtlantic Bancorp A 
Business Risk: Average
Economic Moat: Narrow
Price/Fair Value Ratio*: 0.66
Consider Buying: $11.60
Consider Selling: $18.80

BankAtlantic Bancorp is seeking to become "Florida's Most Convenient Bank." This regional bank targets low-cost deposits by providing above-average customer service, including stores that are open seven days a week and maintain longer operating hours than most competitors. In doing so, the company is incurring higher operating expenses, but it is generating improved net interest margins. Its management plans to open 27 stores this year, representing an almost 30% increase in its base.

While this expansion will likely pressure its earnings over the next few years, analyst Ryan Lentrell believes that deposit growth generated by the new stores should allow the bank to maintain its strong net interest margins and help it compete with the increased presence of larger national institutions in the long run. Greater emphasis on operating efficiency throughout its network should also lead to an improved cost structure over time. Rising interest rates and a deteriorating real estate market still represent headwinds for BankAtlantic, but once again, we like the trade-off between the potential risk and reward.
Full Analyst Report:  BankAtlantic

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* Price/fair value ratios were calculated using fair value estimates and closing prices as of May 9, 2007.

John Owens contributed to this article.

Heather Brilliant does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.