By Steven D Alexander

Small cap stocks need not be hot tip penny stocks or speculative growth stories based on an idea and a prayer. There are plenty of quality, undervalued small cap stocks out there, and this article tells you how to find them.

1) Find the Big Fish in Small Ponds

It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and we do not want to be speculators but investors.

So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!

For an example of this, consider Winnebago (WGO). At under 500 million market cap, this is clearly a small cap stock. Motor home manufacturing is not a lucrative market with wide appeal. Because of this, few new competitors bother to enter it - only about 10 companies control the market. Winnebago is the big fish in this small pond, with over 20% share. Because of this, the company has been able to maintain (and even increase) pricing, continue to build brand equity, and reward shareholders with dividend hikes and buybacks. Winnebago has averaged well over 20% return on equity for over 10 years - a sign of a potential competitive moat.

2) Management Matters

In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).

With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.

To value management, look for founder CEOs that own a large stake in the company - preferably 10% or more. This aligns their interests with yours. Founder CEOs of small caps with strong profitability records likely have a good strategy and have been successful putting it to work. Beware of small caps with vagabond management or those that use shareholder capital to give themselves generous salaries or perks.

3) Debt is Dangerous

This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.

Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky, and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.

Ideally, you want to pick small caps with no debt whatsoever. Minimal debt can be helpful, but be wary of stocks with a debt-to-equity ratio over 30%.

4) Diversify

When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see it's business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a very focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.

Take for example a MFI stock, Select Comfort (SCSS), the maker of the Sleep Number bed. Just a year and a half ago this company looked like a great buy, driving returns on equity well over 30% and growing revenues and earnings in the 20% range (and with no debt to boot). But a number of challenges all hit the company at once. The housing market went into a deep decline, competitors like Tempur-Pedic (TPX) gained ground, and soon Select Comfort found it's only product under siege. Sales and earnings tanked, and the stock has dropped from the mid-20's into penny stock range.

For these reasons, you MUST diversify when buying small caps. Even the most attractive opportunities are not immune to stock price swan dives.

5) Never Forget the Fundamentals

The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (15-25% return on equity, 25% or higher return on invested captial), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.

Another great sign in a small cap is the payment of dividends. Dividends are a very underrated part of total stock returns. In his book The Future for Investors, Wharton professor Jeremy Siegel calculates that reinvested dividends would have accounted for the majority of S&P 500 index returns over the past 60 years. Not only this, but the payment of dividends is tangible proof of a company generating excess cash flow. Instead of blowing those extra cash flows on overpriced acquisitions, they are paid out to their rightful owners - the shareholders. Paying out this excess cash also optimizes return on capital.

Don't be Afraid of Small Caps!

Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. However, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up.


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