Which Stock Can Pass This Tough Test?

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This article is part of ourRising Star Portfolios series.

Today, my search continues for some great small- and mid-cap stocks to add to my real-money "multivitamin" portfolio. Friday, I revealed the results for this month's Foolish 8 screen and came up with 12 candidates. Those stocks are being tracked on the F8's own CAPS page.

Today, we turn to the Modified Foolish 8.

Except ...

It's lonely at the top
For the second month in a row, not a single stock passes the Mod 8 screen. I'm actually quite pleased this is happening, and I have no inclination to loosen the requirements just to get a few companies to pass. The criteria are tough for a reason.
For a refresher, here's a summary of the changes I made to turn the Foolish 8 into the Mod 8:

  • Raised the revenue cap to $900 million or less.
  • Took the $25 million limit off the daily dollar volume requirement, making it simply $1 million or greater.
  • Loosened the relative strength requirement to 50 or greater.
  • Required not only positive cash flow but also positive free cash flow.
  • Required a price-to-free-cash-flow-to-cash-flow growth (PFCF-to-FCF growth) multiple of 1 or less. I have tweaked the screen to use actual FCF growth over the past year.
  • Required greater than 15% return on equity over the past four quarters, and for each of the past three fiscal years.

According to the independent American Association of Individual Investors, or AAII, the Mod 8 has had average annual returns of 15% from January 1998 through October 2011. The S&P 500 averaged 1.9% annually over that period. The AAII methodology involves buying a stock the month it appears on a screen and selling when it's off -- something we'd never do in real life but that we will do while tracking our results.

Four to consider
Today I want to highlight four companies that almost passed the screen, failing on only the return-on-equity requirement. Each of these had greater than 15% ROE over the past four quarters and the past two fiscal years, missing on only that most distant third fiscal year. They are all also on this month's Foolish 8 screen, as explained in Friday's article.

SolarWinds (NYS: SWI) has a name that suggests that it's involved in two types of emerging alternative energy, but it's not. SolarWinds makes software for IT professionals, mostly to help them manage their networks. The company is doing its best to disrupt the industry by providing lower-cost solutions that are flexible and scalable. It's a fast-grower and, trading at 26 times forward earnings, priced as such.

Altisource Portfolio Solutions (NAS: ASPS) provides mortgage management services for loan originators and loan servicers, as well as other financial services. Had its fiscal 2008 ROE of 13.5% been 1.5 percentage points higher, this company would have passed the Mod-8 requirements. I'm guessing it will pass the screen next month.

Epoch Investment Partners (NAS: EPHC) has a strong and growing business as an investment advisory and investment management services provider for institutional and high-net-worth clients worldwide. It has grown assets under management (AUM) at an extremely impressive rate, from $800,000 in 2004 to more than $17 billion today. With a third of its revenues coming from overseas, Epoch has good international growth potential.

Hi Tech Pharmacal (NAS: HITK) makes drugs in three categories: generics, prescription, and over the counter. The drugs treat various conditions including glaucoma, asthma, and bronchial disorders. Its growth is quite impressive, especially given its forward P/E of 10.

Onward and upward
So, nothing this month from the Modified Foolish 8, but the small caps that passed Friday's Foolish 8 screen are still in play for me. I'll soon report back on whether any of them are a good fit for the portfolio. So far, I've bought four stocks off these two screens: LSB Industries, lululemon athletica, II-VI, and Kulicke & Soffa.

If you're interested in keeping up with any of these companies, just add them to your free watchlist -- and you'll gain access to The Motley Fool special report "Six Stocks to Watch from David and Tom Gardner."

At the time this article was published Fool analyst Rex Mooretweetsbut is not a twerp. He runs a real-moneyRising Star portfoliobased on his screens. Of the companies mentioned here, he owns shares of lululemon athletica. The Motley Fool owns shares of II-VI, lululemon athletica, and Kulicke & Soffa Industries.Motley Fool newsletter serviceshave recommended buying shares of II-VI and lululemon athletica. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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