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Jubak's Journal
Recent articles:
• The threat of the job-is-worth-less recovery, 10/24/2003
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| | Jubak's Journal
10 microcaps for macro profits
Small stocks outperform large caps in the early stages of a recovery and should hold their lead as this modest rebound rolls on. Here are 10 microcaps that should do nicely.
By Jim Jubak
In the early stages of an economic recovery, the stocks of small companies outperform the shares of the big guys.
Take a look at the 3,000 U.S. stocks that the Frank Russell Co. tracks for its indexes.- So far in 2003, the Russell 1000 ($RUI.X) stock index, which tracks the performance of the stocks of the largest 1,000 companies, is up 17%.
- The Russell 2000 ($IUX), which tracks the performance of the smallest 2,000 stocks, is up 32% for the year to date. (The stocks in the Russell 2000 account for about 8% of total market capitalization of the Russell 3000.)
Often, as an economic recovery advances, big-company stocks begin to make up the difference. Thats because these companies can use their massive advantages of scale to reap more than their share of the economic pie.
Small victories, big gains
But in this economy, small-company stocks are likely to continue to lead the way. Thats because the economy is rebounding in this recovery at a slower pace than usual, and it looks like growth will remain relatively modest even as the recovery continues. That will play to the leverage thats built into small-company stocks, which are far more likely to react to even modest increases in sales and earnings than big companies. The latter have to show massive increases in sales volume to produce a measurable change in their bottom lines.
Think of it this way. General Electric (GE, news, msgs) added $668 million in sales in the third quarter of 2003 from the same quarter of 2002. But that was a paltry 2% of the companys $33.4 billion in third-quarter revenues.
On the other hand, a company like Calavo Growers (CVGW, news, msgs), one of the stocks on my list of micro-cap winners, increased sales of its avocados and papayas by a comparatively tiny $4.9 million in the third quarter of its fiscal 2003 from the same period in 2002. But that amounted to a 6.5% increase from the $76 million in sales recorded in the fiscal third quarter of 2002.
Guess which stock is up more in the last three months? Calavo Growers, which began life as an avocado cooperative in California and bills itself the first name in avocados, gained 16% in the period. GE is down 1%.
10 likely micro-cap winners
In other words, the way to make macro profits from the current economic recovery is by putting some money in microcaps. And Ive put together two screens and followed up with some due diligence on individual stocks to identify 10 microcaps likely to outperform the average stock.
| 10 microcaps worth looking at | | Stock | Industry | Market capitalization (millions) | Shares outstanding (millions) | Analysts covering stock | YTD return | | American Vanguard (AVD, news, msgs) | Agricultural chemicals | $166 | 5.8 | 0 | 94% | | Atlas Pipeline (APL, news, msgs) | Natural gas pipelines | $152 | 4.4 | 1 | 46% | | Calavo Growers (CVGW, news, msgs) | Avocados and produce | $108 | 12.9 | 0 | 19% | | Cohesant Technologies (COHT, news, msgs) | Adhesives | $14 | 2.6 | 0 | 38% | | Concorde Career Colleges (CCDC, news, msgs) | Education and training | $124 | 5.9 | 0 | 67% | | Fargo Electronics (FRGO, news, msgs) | Business software & services | $166 | 12.4 | 4 | 53% | | Great Northern Iron Ore (GNI, news, msgs) | Iron ore | $132 | 1.5 | 0 | 50% | | Middleburg Financial (MBRG, news, msgs) | Banking | $141 | 3.8 | 1 | 62% | | Onesource Information Services (ONES, news, msgs) | Internet information | $117 | 11.3 | 2 | 34% | | Silent Witness (SILW, news, msgs) | Security and protection services | $64 | 7.5 | 0 | 109% |
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OK, so whats a micro-cap stock, anyway, and how did I put together this list of what I believe are good ones?
Were not talking about penny stocks
Repeat after me: A microcap isnt the same as a penny stock. The latter term is used for any stock that sells for a low price per share, often $5 or less. A micro-cap stock, on the other hand, can sell for a high price per share: For example, Great Northern Iron Ore (GNI, news, msgs), another stock that made my micro-cap list, sells for $89 a share.
No, what makes a microcap a microcap is the combination of price per share and a very small number of outstanding shares. Great Northern Iron, for example, has only 1.5 million shares of stock outstanding. Contrast that with the 10 billion shares of General Electric stock outstanding. Multiply the price per share and the number of outstanding shares, and the total market capitalization of Great Northern Iron is a tiny $133 million, despite its high share price. General Electric, on the other hand, trades for a lower price per share of $28 but has a much higher market capitalization of $280 billion because the company has issued so many shares.
By my definition, then, if you ranked all of the stocks in the market by market capitalization, the microcaps would be those in the lower 25% of the pyramid, with a market capitalization of $200 million or less.
Before you dive in to the micro-cap market, you should know that there is a downside. (Theres no free lunch in investing.) Because there are so few shares outstanding, very few shares of these stocks trade on the average day. Average daily trading volume for Great Northern Iron, for example, is just 2,300 shares. That can make it hard to get in and out of positions even for individual investors. And it certainly makes it impossible for most large institutional investors to buy these shares.
Sifting for winners
How do you identify good investments in the world of microcaps? Forget about Wall Street analysts. As you can see in the table above, most microcaps arent followed by any analysts. Thats not surprising. Since theres almost no institutional buying or selling interest in these stocks, Wall Street doesnt have a reason to produce research on them. Microcaps arent exactly profitable investment banking clients, either. So count out investment banking fees as motivation.
In the micro-cap world, stock screens -- and word of mouth -- are an investors best friends. To come up with my list of 10 microcaps for macro profits, I tweaked two screens that I built recently to look for unknown mid-cap blue chips. You can see my original thinking on unknown stocks in my Oct. 14 column, "8 great blue chips youve never heard of." For cash-cow stocks, see my Oct. 21 column, "10 big, fat cash cows."
The simple tweak? Instead of ruling out all stocks with market caps of under $200 million, I required every stock on the list to have a market capitalization of $200 million or less.
After due diligence on the 27 stocks that made the first cut of either of these two screens, I wound up with nine microcap candidates. I added one stock that didnt make either list, Calavo Growers, but it had popped up on my personal radar a few months back.
What do these stocks have in common? Not their structure, their industry, their market share or their technologies.- Higher yields. Atlas Pipeline Partners and Great Northern Iron Ore are structured as a partnership and a trust to pass almost all earnings through to investors. Atlas yields 6.6% while Great Northern Iron yields 7%.
- Niche dominance. Some, like Calavo Growers, are dominant companies in small niches that are using profits to expand into new markets. In Calavos case, that means selling avocados to new customers in Japan, where sales grew by 40% in the most recent quarter, and adding papayas and prepared foods to its product line.
- Scavenging. Others thrive by being tough competitors in a business dominated by larger companies. Agricultural chemicals producer American Vanguard is finding a way to make a profit by buying product lines that larger companies have abandoned.
- Hot trends. Education and job training in the case of Concord Career Colleges, and video security and surveillance gear in the case of Silent Witness.
- New blood. Others on my list have found growth in old industries such as adhesives (Cohesant Technologies) and banking (Middleburg Financial).
But since I started with two screens that emphasize cash flow and consistent earnings growth, these microcaps share many of the fundamental characteristics of their larger blue-chip brethren. (Although because of the volatility that comes with smaller daily trading volumes, I wouldnt put any of these stocks in the blue-chip category. Theyre intrinsically riskier than that.)
Consistently strong returns
For example, Silent Witness shows a return on equity of 35% over the trailing 12 months. Return on equity was 31% at Concorde Career Colleges, 25% at Onesource Information.
Fargo Electronics shows positive year-to-year earnings growth in seven out of the last eight quarters. Middleburg Financial has delivered that kind of growth even more consistently, with year-to-year earnings growth in each of the last 10 quarters.
Youll find consistency on the performance side too. American Vanguards worst performance in the last five years is a 3% loss in 1998. Cohesant Technologies shows an annualized average return of 30% over the last five years.
I think those kinds of numbers stack up against those delivered by much larger companies.
Good stocks can come in small packages.
New developments on past columns
The threat of the job-is-worth-less recovery
More data from the U.S. Commerce Department on what is going on with income in this very unusual economic recovery are due in the departments quarterly report on Thursday. The data, according to the economists and policy analysts who have seen some part of the report, are expected to show median hourly wages rising in the quarter but the average number of hours worked weekly falling. The effect is that total income is down for the quarter. Unless you include the effect of the Bush tax cuts and home refinancings. In which case its up. All adjusted for inflation. The Federal Reserve got a look at the full report before making todays decision on interest rates.
3 stocks to navigate a tricky quarter
On Oct. 16 Reliance Steel and Aluminum (RS, news, msgs) announced third quarter 2003 earnings of 39 cents a share, up 26% from the 31 cents a share the company earned in the third quarter of 2002 and way ahead of the 25 cents a share expected by Wall Street analysts. The results were helped by the companys July acquisition of Precision Strip for $220 million in cash and $26 million in assumed debt. So, its a good idea to take the earnings growth with a grain of salt. But other fundamentals also showed solid improvement to support the earnings story: gross margins climbed to 27.8% in the quarter from 26.2% in the second quarter of 2003. The company also continued to pay down debt. The company projected earnings per share of 25 cents to 30 cents for the fourth quarter. The Wall Street consensus is for 29 cents a share. As of Oct. 28, Im leaving my target price on this stock at $32.20 with a deadline of July 2004.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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