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

In times of economic duress--and particularly when inflation threatens--it's important to focus on companies with economic moats. These tend to be firms with some pricing power and that can raise their own selling prices in line with input costs. The resulting universe has an average market cap of $800 million and an average daily trading volume of 714,500 shares.

And Morningstar Rating for Stocks = 5 Stars

Naturally, we focus on stocks that currently have 5-star Morningstar Ratings. This means they trade at enough of a discount to our estimated fair values to warrant our strongest buy recommendation.

And Morningstar Financial Health Grade <= C

We also require an arm's length distance from financial distress, which Morningstar's Financial Health Grade is designed to estimate. Particularly among small companies--which tend to have less-diversified revenue streams than larger companies--financial health is crucial to viability.

Here are four stocks that made the cut in June.

Actuant ATU
Actuant is composed of seemingly unrelated businesses that are glued together with deep distribution networks and a strong Asian sourcing group. These strategic assets give Actuant the ability to develop and deliver its products at a lower cost than others in the industry. Coupling this cost advantage with broad diversification across customers, product lines, and geographies has allowed Actuant to grow profitably in the face of competition and market cyclicality. A key part of Actuant's growth strategy has been acquiring smaller companies that can be easily deployed to supplement its core industrial business.

ATMI ATMI
ATMI is a top supplier of materials used during chip fabrication. The firm will benefit from continued advances in semiconductor technologies, but it is presently mired in a severe cyclical downturn in business conditions. Demand is driven by the number of wafer starts (the number of silicon wafers placed into production) in the semiconductor industry, as ATMI's materials (such as gases, liquids, and various chemicals) are consumed during manufacturing. Therefore, ATMI's business is much steadier than those of chip equipment suppliers, which depend on chipmakers' volatile capital spending. Since the firm disposed of the last of its noncore chip equipment business in 2004 and focused solely on consumables, profitability has improved substantially. Moreover, because the material business is not particularly capital-intensive and operating margins of 20%-plus are achievable, we think ATMI's returns on invested capital can increase to the upper teens in the long run.

Fair Isaac FIC
Fair Isaac developed and maintains the FICO score that accompanies all consumer credit reports. When an individual applies for a loan, the lender will pull a report from one or all of the credit bureaus-Equifax EFX, Experian EXPGY, and TransUnion. Fair Isaac's algorithm is applied to the consumer's credit data to generate the FICO score. This method of scoring has become so entrenched at banks and other loan agencies that switching to a new scoring method would require a significant amount of time and money to retrain loan officers and modify systems. Lenders have little reason to switch away from the FICO score as no other product has proved as reliable. Also, FICO scoring represents a small sliver in the very large financial-services pie, creating little economic incentive for users to switch scoring methods. These factors combine to make FICO scoring extremely profitable for Fair Isaac. Operating margins in this segment usually hover around 60%.

International Speedway ISCA
International Speedway benefits from barriers to entry that prevent other track operators from competing in its markets, as well as substantial intangible assets that keep fans loyal to its tracks. These competitive advantages give the firm a wide economic moat. Nascar, like most sports, has strong traditions. Fans and drivers are accustomed to having certain races at certain tracks on certain dates, and any change would probably result in significant backlash. This provides a reliable revenue stream for International Speedway, as it can count on Nascar to distribute races in a predictable way each year. Because fans' loyalty to tracks is so strong, it would be extremely difficult for any competitor to enter a region with an existing track and usurp its races--just as it would be difficult for Wrigley Field to lose the Cubs to a newly built ballpark in Chicago.