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26 Small Stocks

Over the last two years, Quan and I failed to find as many good, small stocks for the newsletter as we should have. We did Breeze-Eastern which was small. We also picked Ark (ARKR), Tandy Leather (TLF), and Village Supermarket (VLGEA). All of those are under $500 million in market cap. America’s Car-Mart (CRMT) is also on the small side. But, it’s a financial stock.

If your biggest problem with sifting through small stocks is getting rid of the low quality and high risk stocks in the group – there’s an easy screen for this.

Just look for stocks that:

1. Have been public a long time
2. Have a long history of profitability
3. Have an adequate Z-Score
4. Have an adequate F-Score

This won’t leave you with a list of good stocks. But, it will remove the junk. This is a value investing blog. So, we’ll insist on an enterprise value no higher than 10 times EBIT (ideally, it would be 10 times peak EBIT – but that’s harder to screen for).

If we apply these 5 criteria – 1) didn’t go public recently, 2) decent history of past profits, 3) decent Z-Score, 4) decent F-Score, 5) decent EV/EBIT – we are left with 26 U.S. stocks with a market cap under $500 million:

• Armanino Foods of Distinction (AMNF)
• Jewett—Cameron (JCTCF)
• Medifast (MED)
• Span-America (SPAN)
• Espey Manufacturing (ESP)
• IEH (IEHC)
• Educational Development (EDUC)
• Chase (CCF)
• Shoe Carnival (SCVL)
• Air T (AIRT)
• Flanigan’s (BDL)
• Comtech Telecommunications (CMTL)
• Eastern (EML)
• Miller Industries (MLR)
• ADDvantage Technologies (AEY)
• Collectors Universe (CLCT)
• Houston Wire (HWCC)
• Wayside Technology (WSTG)
• Lakeland Industries (LAKE)
• Taylor Devices (TAYD)
• Zumiez (ZUMZ)
• Core Molding (CMT)
• Natural Gas Services (NGS)
• Universal Truckload (UACL)
• Acme United (ACU)
• Preformed Line (PLPC)

This list excludes stocks I’ve already picked. Tandy, Village, and Ark would be on the list if that wasn’t the case.

Sorting through that list then becomes a matter of personal preferences and biases. For example, I’d be less likely to research Zumiez – which is a specialty retailer (it’s basically a mall based chain of stores selling skateboarding related clothes, etc. aimed at teens) because Quan and I rarely consider investing in retailers. I might be more likely to look at Collectors Universe and Miller Industries because they have big market share in their niches (collectibles grading and tow trucks respectively).…

Closing the Book on Breeze-Eastern

Quan and I did an issue on Breeze-Eastern last year. The stock has since been acquired by TransDigm (TDG). When we did the issue Breeze-Eastern was priced at $11.38 a share. We appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of Breeze-Eastern.

What lesson can we learn from our Breeze-Eastern experience?

Here’s what we said about Breeze-Eastern’s stock price at the end of our issue:

“Breeze should – based on the merits of the business alone – trade for between 10 and 15 times EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention based on anything but its numbers. This might cause investors to underappreciate the qualitative aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock will not hold it for the long-term. They may want to sell the company.”

(Breeze-Eastern Issue – PDF)

Last year, Value and Opportunity did a blog post called “Cheap for a Reason”:

“Every ‘cheap’ stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil&gas, emerging markets exposure) or a combination of both.

The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.”

So, why was Breeze-Eastern cheap?

Quan and I thought it was that the company had been spending on developing new projects in the recent past that wouldn’t pay off till the future:

“Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s gross margin and operating margin will be higher in the future than they were in the last 10 years.”

The merger document for the acquisition includes a projection by the company’s management to its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay more for Breeze than the stock market had often valued the company at was because:

1. Breeze will have lower costs as it spends less on development projects
2. AND Breeze will have higher sales as a result of the development projects it spent on in the recent past

The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a 15% annual earnings growth rate. The projected growth is largely due to management’s belief that revenue from platforms under development will go from $0 in 2016 to …

Closing the Book on Breeze-Eastern

Quan and I did an issue on Breeze-Eastern last year. The stock has since been acquired by TransDigm (TDG). When we did the issue Breeze-Eastern was priced at $11.38 a share. We appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of Breeze-Eastern.

What lesson can we learn from our Breeze-Eastern experience?

Here’s what we said about Breeze-Eastern’s stock price at the end of our issue:

“Breeze should – based on the merits of the business alone – trade for between 10 and 15 times EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention based on anything but its numbers. This might cause investors to underappreciate the qualitative aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock will not hold it for the long-term. They may want to sell the company.”

(Breeze-Eastern Issue – PDF)

Last year, Value and Opportunity did a blog post called “Cheap for a Reason”:

“Every ‘cheap’ stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil&gas, emerging markets exposure) or a combination of both.

The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.”

So, why was Breeze-Eastern cheap?

Quan and I thought it was that the company had been spending on developing new projects in the recent past that wouldn’t pay off till the future:

“Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s gross margin and operating margin will be higher in the future than they were in the last 10 years.”

The merger document for the acquisition includes a projection by the company’s management to its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay more for Breeze than the stock market had often valued the company at was because:

1. Breeze will have lower costs as it spends less on development projects
2. AND Breeze will have higher sales as a result of the development projects it spent on in the recent past

The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a 15% annual earnings growth rate. The projected growth is largely due to management’s belief that revenue from platforms under development will go from $0 in 2016 to …

14 Stocks For You To Look At

14 Stocks For You To Look At

The Two Sides of Total Investment Return

A Simple Way to Think about Moat

Moat is really about protecting a company’s profit as Warren Buffett said:

“You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.”

A business may make less profit because of lower sales, lower margin, or both. So, there are two sides of moat: the sales side and the margin side. The sales side can be broken down into customer retention and customer acquisition.

Customer Retention

There are many factors that lead to high retention, including customer behavior, price insensitivity, switching cost, etc.

Customer behavior is subtle. Sometimes customers just don’t think about switching. I used to wonder how small banks can compete with big banks. I realized that a bank’s moat doesn’t come from low funding cost or low operating cost but actually from customer habit. Customers rarely change their primary banking account. So, a small bank may have a low ROE because of its high costs but it can still have stable local market share. Despite their big scale to sell many financial products, big banks can’t steal business from small banks very easily.

Similarly, car owners rarely shop for a new insurer unless there’s a bad experience, there’s a major event in their life (move or marriage) or there’s a spike in the price of their premiums. In fact, insurers like State Farm and Allstate have greater retention rate than Progressive and Geico because they sell bundled products. So, even though Progressive and Geico have a huge cost advantage, they have only low double digit market share after decades of gaining market share. There are simply not many people shopping for new car insurance policies each year.

Price insensitivity helps retain customers in the face of price competition. Customers may pay little attention to price when it’s a tiny part of their total spending. Switching from Coca Cola to a private label cola simply doesn’t save much.

Even better, some customers are willing to pay more for convenience, tailored solutions, product quality, or customer services. I find it interesting that Frost often pays less than one-tenth of the Federal Funds Rate for its interest-checking deposits. For example, Frost paid only 0.47% on its interest-checking deposits in 2007 while many other banks paid about 1.50%. I’m not sure why but perhaps Frost’s customer service is so good that customers simply don’t care about getting interest income on their deposits.

Customer Acquisition

Strong customer acquisition can be achieved through distribution, mindshare, product superiority, or price.

The best example of distribution power is perhaps big food companies. By owning key brands, they have the power to convince retailers to carry new …