These Micro-cap Stocks Are Surging -- And Still Have 50% to 100% Upside

When I write about micro-cap stocks (which typically have market values of less than $200 million), I always focus on several at once.

This approach highlights the necessity of ensuring that any one of these speculative stocks doesn't account for more than a sliver of a portfolio. Some micro-caps can fare quite well, while others sink like a stone.

I was thinking about this basket approach to micro-caps recently while reviewing a column [1] I wrote early last year.

Since then, GSE Systems (NYSE: GVP [2]) has been a dud, dropping 26% as the company's focus on nuclear power-plant training services has fallen out of favor. But the other two picks in that column are faring quite well and appear to still have ample upside. Looking at the reasons why that's the case can also point the way to the pillars of success in micro-cap investing.

1. Biolase Technology (Nasdaq: BIOL [3])
Stock in this maker of laser-based dental drills moved sideways for the rest of 2012, but it has risen more than 150% in 2013. A key shift in sales tactics gets the credit.

Biolase had been relying on dental products distributor Henry Schein (Nasdaq: HSIC [4]) to help boost sales but found that the indirect sales approach was just too tough. Biolase's equipment is relatively pricey, and dentists need to develop a deep understanding of why this upfront investment in laser drills can reap big gains for a dental practice down the road. Patients love them because they are relatively pain-free, and dentists love them because they can drill much more precisely.

As analysts at Ascendiant Capital recently noted, "because it is designed to provide clinically superior performance with less pain and faster recovery times, the company's Waterlase device has the potential, in our view, to become the instrument of choice for common procedures such as cavity removal or root canals."#-ad_banner-#

The decision to ditch Henry Schein and emphasize direct sales has really begun to pay off. Sales are on track to rise 20% this year and again in 2014 (to around $80 million), according to consensus forecasts. Even at that level, total penetration in the domestic dental industry will still be less than 10% (and below 3% on a global basis), highlighting ample growth opportunities for market share gains.

Yet a broad review of Biolase's 160 patents (and 150 patents pending) shows that this company is aiming far beyond the dental market. Biolase's lasers have the potential to provide similar benefits in the fields of dermatology, ophthalmology, orthopedics and urology. Biolase has limited resources, and it will probably need to pursue licensing or partnership agreements to crack these markets, but these niches represent huge potential upside if the company gains traction.

As noted, this micro-cap has several important features you should look for, including:

• Positive cash flow, which means the share count won't need to be diluted to keep the business going.
• A relatively low penetration rate, which implies robust long-term growth potential.
• A management team that is delivering solid sales execution.
• Rising daily trading volume (which was around 100,000 shares a day when I looked at the company last year, but now exceeds 300,000 on most days, highlighting increased Wall Street awareness of the company).

I see this stock rising from a recent $4.75 to $7, which equates to three times projected 2014 sales, a reasonable multiple for a high-growth company with gross margins approaching 50%.

2. Axcelis Technologies (Nasdaq: ACLS [5])
My pick of this semiconductor capital equipment was admittedly premature. I noted that shares traded below tangible book value and simply needed catalysts to move back above tangible book. Well, shares fell even further over the rest of 2012, moving deeper below book value.

Make no mistake: This is a company that seemingly lost relevance in the very competitive chip equipment industry. Sales slumped from $500 million in 2004 to just $200 million in 2012. Equally important, an extended period of negative free cash flow brought cash levels down from $200 million six years ago to just $45 million by the end of 2012.

Yet as is the case with Biolase, this stock is finally gaining traction, moving up sharply in the past few months.

Why the sudden spike? Because a recently launched new product line appears to be on the cusp of solid traction. Axcelis launched the Purion product line in 2012, which is used to implant ions on semiconductor wafers. Whereas Axcelis' legacy product line, known as Optima, was focused on just a 15% slice of the $1 billion ion implantation market, Purion is aimed at the other 85%.

The company has already sold three Purion systems to a leading (if undisclosed) memory chip maker and a semiconductor foundry. These sales are for "evaluation systems" and are often a harbinger for an order for many more units to come -- if the Purion product line lives up to the company's billing.

This isn't just about product line upgrades. Shares are also gaining from an expectation that the broader chip equipment industry is on the cusp of a sustained upturn. You can see that newfound optimism by noting that shares of industry leader Applied Materials (Nasdaq:AMAT [6]) have risen 40% over the past six months.

And AMAT's rise highlights just how cheap Axcelis remains. While shares of AMAT, Lam Research (Nasdasq: LRCX) and KLA-Tencor (Nasdaq: KLAC [7]) all trade for roughly two times forward revenue, on an enterprise value basis, Axcelis trades for just 0.7 times projected 2013 revenue. Simply moving that multiple up to 1.5 implies a double for this stock.

That gain will come only if Axcelis' Purion product line gains the traction that management is anticipating. But the spate of recent orders for evaluation systems is promising.

Risks to Consider: Micro-caps are starting to gain traction as the market moves higher and investors move out on the risk curve. TheiShares Russell Microcap Index ETF (NYSE: IWC [8]) is up 23% over the past six months, compared with a 17% gain for the S&P 500. Yet these stocks can get hit hard if the market changes direction and investors make a flight to safety.

Action to Take --> Both Biolase and Axcelis had fallen off of many investors' radars in 2012 but are moving back into vogue this year, as seen by impressive recent price gains. Crucially, these companies' management teams are laying the foundation for solid growth in the years ahead. If they can execute on their plans, then ample upside could be ahead for these stocks.

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.