Small Caps for the Picking

Small Caps for the Picking
by Pat Dorsey, CFA
Morningstart, 08-11-06

As regular Morningstar readers know, we've been pounding the table for high-quality large caps for quite some time now. Lo and behold, it seems that the tide may finally be turning: Morningstar's Large-Cap Index is now ahead of our small-cap index both year-to-date and for the trailing year. Over the past three months, in fact, small caps have lost almost 12%, while large caps have held up pretty well, with a 3% loss.

This is a really great development for a couple of reasons. For one, it means that almost two years after initially advancing the notion that lower-risk, high-quality large caps were cheap relative to generally riskier small fry, I might finally be right. (Long stretches of looking dumb are an occupational hazard in the stock analysis profession.) But even better, the poor recent performance of small caps means that, in typical fashion, Wall Street has been throwing the baby out with the bathwater, and there are now some very interesting smaller companies that are cheap enough to buy.

So, I trolled our coverage universe of more than 1,800 stocks--which includes about 600 small caps--for some of the most promising smaller companies that we cover. Here's what I came up with.

Although Blue Nile NILE would be near the top of the list alphabetically, it would still be at the top even if the online diamond merchant were named Zambezi. The firm has a beautiful business model with negative working capital--the firm holds no inventory, so Blue Nile doesn't need to pay suppliers until after the consumer has paid for the diamond--that generates enormous returns on capital. Moreover, the firm has a management team that seems to understand the importance of capital allocation, rather than growth for growth's sake, as evidenced by management's decision to pull back on paid search advertising late last year when keywords became too expensive. Although the shares popped recently on the heels of a solid earnings report, we think they still have substantial upside.

Another high-quality smaller name that looks attractive is for-profit education company DeVry DV , which saw enrollment in its technology-related programs get whacked during the bursting of the tech bubble. However, as improved enrollment levels work their way through the firm's multiyear programs, margins should improve nicely, and the firm has not suffered from any of the investigations that have dogged some of its peers. At 15 times cash flow, the shares look pretty attractive to us.

Sticking with the growth theme, logistics firm Forward Air FWRD has seen its shares plunge recently on fears of a slowing economy to a point at which we think they offer a compelling value. This asset-light firm occupies an interesting niche of the transportation industry, moving freight via truck between airports with such efficiency that customers use it as an alternative to pricier air-cargo services. The firm has a great track record of creating shareholder value, and we think that it has many years of excess returns ahead of it.

These are three very high-quality firms trading at fair prices. Moving down the quality--and valuation--scale somewhat, I'd highlight three more companies that are all solid and trade at very attractive prices. It's an eclectic group: a beaten-up specialty retailer, a slumping casual-dining chain, and the owner of two great education brands.

Tuesday Morning TUES is the beaten-up retailer, and it has suffered from the same slump in houseware spending that's taken Pier One PIR from $20 to $6 over the past couple of years. The difference is that Tuesday Morning has no debt, is still generating meaningful free cash flow, and occupies a defensible niche--selling branded closeout goods. This is a very solid little company that's gotten very, very cheap. Even better, the private equity firm that took it private about 10 years ago still has a sizable stake, which means it may very well just take the company private again if the share price stays as cheap as it is now.

The casual-dining chain is Applebee's APPB , which caters to a less-well-off clientele that's been pinched badly by higher gas prices. This is not great, but neither is it a terminal problem, and we think Applebee's has more sticking power than most restaurant chains given its scale, advertising muscle, and unique attributes, like an exclusive alliance with Weight Watchers WTW . A reasonable top-line growth estimate coupled with steady margins yields a fair value estimate almost twice the current price.


The smallest of the firms in this group is Educate EEEE , which operates Sylvan Learning tutoring centers and owns the well-known Hooked on Phonics brand. The firm's management has made a hash of things over the past year by getting too aggressive in an ongoing plan of buying back franchised Sylvan centers; this seriously damaged operational performance. As a result, the shares have been absolutely hammered. However, the brands are still strong, the demand for tutoring services is still solid, and the operational problems are fixable. We think the shares are cheap enough to be worth a look, and we also think that Educate's majority owner--private equity firm Apollo Management--could very well make a bid for the whole company.

Finally, we have three small caps that all have serious warts, but which are all so dirt cheap that adventuresome types should give them a look. Homebuilder Levitt LEV trades for just 60% of book value, and while the shares may very well take time to turn around, the current stock price assumes a doomsday scenario that we think is unlikely to occur. Radware RDWR is an Israel-based maker of networking equipment that's got solid products, decent growth potential, and a dirt-cheap stock--net of the firm's almost $9 per share in cash, the shares trade at just 1 times our 2006 sales estimate. (Radware could also make a tasty treat for one of the major networking companies.)

Then there's video-game company Take Two Interactive TTWO , which has some of the worst corporate governance we've seen, but also owns the amazingly successful Grand Theft Auto gaming franchise. We estimate this one game alone is worth about 40% more than the current share price, and that the whole company (which does have some other successful games) could be worth as much as twice the current share price. This one's not for the timid, but a large enough margin of safety can compensate for a lot of risks.