This week, we follow up on our previous two Newsletter Watch columns, returning to favorite ideas among small-cap funds, as well as a look at two small-cap stocks that fit the "guru strategy" of Warren Buffett.

Two weeks ago, we featured favorite small-cap funds from Jim Lowell. Here, we add a new trio of advisors who see upside potential in small-cap funds and ETFs.

Carl Delfeld, of Chartwell ETF Advisors, is known for his expertise in exchange-traded funds, and his latest "pick of the week" is a bet on the iShares MSCI Japan Small Cap (NYSE:SCJ). The reasons behind DelFeld’s selection are as follows:

1) Small-cap Japanese stocks listed on Japan's second section are collectively trading at below book value.

2) Japanese market is exhibiting stronger momentum.

3) Japanese small-cap stocks are less affected by yen and U.S. dollar fluctuations.

4) Expectations for Japanese economic growth are very low with upside surprise likely.

An added catalyst, he suggest is that global equity managers are scrambling to gain market weighting for Japan after being underweight for some time.

Meanwhile, Thurman Smith, editor of Equity Fund Outlook, sees opportunity in Intrepid Small Cap (MUTF:ICMAX). "Over its first year and a half, the fund lagged its small-cap value competition, but it has held up well enough in the last seven months to deliver an annualized return of 8.2% over its 2.5-year life, a return almost [three times] that of the MSCI Small Cap Value Index," Smith says.

He says that the main focus of this "little-known fund" is on stocks with predictable revenue streams, and that are in industries with high barriers to entry.

Smith points out that Intrepid is a Florida boutique headed by Mark Travis. With a low risk rating, he says, "Intrepid Small Cap might interest conservative investors who want coverage in this area and are willing to accept modest up-market performance compared to other small-cap funds."

Finally, Leonard Goodall, editor of No-Load Fund Portfolios sees potential in the Vanguard Small Cap Value Index Fund (MUTF:VISVX), which he owns as part of his domestic dollar cost averaging portfolio.

Its return in recent years shows gains of 37% in 2003, 23% in 2004, 6.5% in 2005 and 19% in 2006. The fund had a loss of 7% in 2007 and is down 3.6% so far in 2008.

"This low annual expense ratio (0.23%) index fund attempts to match the performance of small capitalization value-oriented stocks. Being no-load, it works well for dollar averages as no fee is assessed when periodic purchases are made."

Meanwhile, last week we looked at John Reese's newsletter, Validea, which selects stocks based on the investment criteria of "legendary" stock investors.  One such "guru" is Warren Buffett.

Known for taking large, multi-billion dollar stakes in companies, it would seem unlikely that Buffett himself would ever target small caps in his quest for stock purchases or acquisitions.

Nevertheless, as a matter of curiosity, Reese recently ran his "Buffett strategy screen" to determine if indeed there were any small-cap stocks that might otherwise fit Warren Buffett's strategy.

"Sure enough, I found that my computer model that mimics Buffett's approach is high on a handful of small caps," Reese says.

Regarding the criteria in this model, he says, "Ever the conservative, [Buffett] likes firms whose earnings are predictable, and 10 straight years of EPS increases is about as predictable as you can get."

Buffett also looks at debt, so Reese's model likes firms that generate enough earnings that they could, if need be, pay off all their debt within two years. In addition, he adds that Buffett is known for seeking out companies with a high return on equity.

Reese says that his Buffett-based model looks for firms that have average ROEs of at least 15% over both the past three years and the past 10 years, and which haven't had an annual ROE lower than 10% in any year of the past decade.

One small cap that passes the "Buffett test" is Balchem (Nasdaq:BCPC), a New York state-based firm that makes specialty performance ingredients and products for the food, nutritional, pharmaceutical and medical sterilization industries, with end users including both humans and animals.

Reese says the company — with a market cap of $432 million — has increased earnings in nine of the past 10 years, has a 10-year average return on retained earnings of 17.7% and has enough annual earnings ($17.5 million) to pay off its debt ($15.2 million) in less than a year.

A second small cap to pass the test is Cascade Bancorp (Nasdaq:CACB). "Over the past 10 years, the Oregon-based community bank has had an average ROE of 19.1% and 15.5% return on retained earnings, indicating management is doing good job,” Reese says.

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