Moats around Small Castles

When pondering companies with economic moats, the names that typically come to mind are the blue chips, from Microsoft MSFT and Procter & Gamble PG on down. But Morningstar analysts actually cover several hundred small-cap stocks that have distinctive competitive advantages of one sort or another.

All told, our analysts cover 900 small-cap stocks. Of those, 200 have Morningstar economic moat ratings of narrow or wide. Some names you or your clients might recognize include Blue Nile NILE (online seller of diamonds), Boston Beer SAM (maker of Samuel Adams), Clear Channel Outdoor Holdings CCO (billboard operator), Fair Isaac FIC (calculator of the ubiquitous FICO score), International Speedway ISCA (operator of Nascar race tracks), and Winnebago Industries WGO (maker of recreational vehicles). But I hazard to guess that most of the small-cap firms that Morningstar covers have probably never crossed your radar screen.

Yes, these companies tend to be riskier than the blue chips. And yes, small caps can get crushed in a deep recession like the one we're muddling through. But some of the firms that Morningstar covers in the small-cap area are truly great companies. Some have wonderful growth prospects; some are potential takeover candidates; and some will simply keep chugging along in their narrow, but profitable niches for decades to come. Given the sometimes dirt-cheap valuations of these companies, Morningstar analysts have consistently found attractive buying opportunities.

Equity Style Box = Small Cap

For this issue's screen, we first narrow in on companies with market caps below Morningstar's official cut-off between small- and mid-cap firms, which is currently $1.6 billion. What kind of universe does this produce? The average market cap of small-cap companies in Morningstar's U.S. equity database is $324 million (excluding pink-sheet stocks). The average daily trading volume is only about 430,000 shares, which contrasts with the 3-million-plus average for mid- caps. As we've written about extensively in these pages, low-liquidity stocks offer a blessing and a curse. The curse is that trading costs are high--large bid-ask spreads and a decent likelihood that a single order can move the price. The blessing, according to research from Roger Ibbotson and others, is that investors have tended to be paid handsomely for putting up with this illiquidity. (See "The Liquidity Premium" in the June/July issue.)

And Revenue TTM < = $2,000

We're putting a revenue screen here in order to focus on small companies. The small-cap universe consists of two types of firms: small companies and fallen angels (formerly large firms that collapsed in market value). While the latter category provides interesting investing opportunities at times, it's also not for the faint of heart, particularly in the midst of a once-in-a-generation financial crisis.

And Economic Moat not = None