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Big Opportunities in Small-Cap Stocks

This screen looks for good buys in a hot part of the market.

David Krempa, 03/22/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

In 2010, the Morningstar Small Cap Index outperformed the Morningstar Large Cap Index by more than 10%. This added to an already long streak of outperformance by small-cap stocks. Small caps have outperformed over the past one-, three-, five-, and 10-year periods. During the past 10 years, small caps have crushed large caps by more than 7% per year on an annualized basis. With no signs that this trend is going to reverse in the near future, we thought it would be worthwhile to scan for some small-cap investments.

Equity Style Box = Small

First, we searched for stocks that fall into the small-cap bucket. Small-cap stocks have a number of advantages over larger stocks. One of the benefits is the ability to grow sales at faster rates. It is a lot easier to increase revenue at high growth rates when a company is only doing $300 million in sales than when it is doing $30 billion. The smaller size of operations also allows small businesses to more quickly adapt and change strategies in response to a changing industry. With smaller stocks, firms also have the extra upside potential from the possibility of being acquired. Although we do not encourage blindly speculating on takeover candidates, if we find companies that we are happy to own as stand-alone businesses, the chance of a takeover is an added bonus.

Of course, all of these benefits must be weighed against the negatives of small-cap stocks, such as fewer scale advantages, less-diversified business operations, and so on.

And (Moat Rating = Narrow
Or Moat Rating = Wide)

When investing in small-cap stocks, it is important to find companies with moats. If a company does not have a competitive advantage, it will not be able to hold off larger competitors for very long. Bigger companies have greater scale and more resources, so they will likely be able to compete in the same market more profitably than a small company. The moat will help fight off competition from larger businesses.

Moats are also important if you are looking for buyout candidates. Most companies would prefer to expand internally, rather than paying a premium to acquire a competitor in order to enter a market. If a small-cap company has an economic moat (whether that is patents or a strong brand) it has something that a competitor can't create on its own.

PEG < 1.0

We also searched for a price/earnings to growth ratio of less than 1. This ratio limits our results to stocks that are trading at attractive earnings multiples relative to their estimated growth rates. The PEG ratio is a quick way to make sure that stocks trading at high multiples have the earnings growth to warrant a high multiple. With a maximum of 1, we will only see stocks that have a price/earnings ratio of less than their estimated earnings growth rate.

Here are a handful of our results that stood out to us as of Dec. 17:

CSG Systems International CSGS
CSG Systems is a leading provider of end- to-end customer-care and billing solutions, primarily servicing clients in the North American cable and satellite television markets. A solid recurring revenue stream combined with high switching costs provides the company with a narrow economic moat, in our opinion. However, changing dynamics in the communication industry present a headwind, potentially limiting growth opportunities.PAGEBREAK

CSG's core competency lies in providing outsourced transaction-processing services to communication service providers, including cable TV, direct broadcast satellite, wireless, and fixed-wire firms. CSG's service offerings allow its clients to manage the entire lifecycle of the subscriber, from account setup and customer activation to billing and invoicing. The company's dominant position is evident from the fact that its services are being used to support more than 45 million subscribers, or about 45% of all U.S. households.

Parexel International Corp PRXL
Parexel is one of the few top-tier contract research providers with the necessary expertise and infrastructure to conduct large clinical trials around the world. With drug-development outsourcing rates expected to increase, we think Parexel will continue to gain share at the expense of smaller competitors.

We raised our fair value estimate to $28 per share to account for cash earned since our last valuation update. After a deceleration in revenue growth in 2010 because of diminished market demand, we expect drug-development spending to soon recover, helping Parexel yield 10% compound annual growth through 2015. Long-term growth will be driven by both increased outsourcing (we project CRO penetration will improve roughly 5 percentage points by 2015), and market share gains, as Parexel captures a greater portion of the dollars spent on R&D.

Ormat Technologies ORA
For investors looking for exposure to renewable energy in their portfolios, Ormat Technologies is one of the best pure-play opportunities we cover. Ormat is well-positioned to take advantage of the growing concern about carbon dioxide emissions and the surge in state renewable portfolio standards. The 2009 stimulus bill provided cash grants in lieu of production and tax credits for renewable financing, which seems to have stimulated project financing activity.

Still, despite winning leases in California and Nevada and geothermal rights in Alaska in 2008, Ormat's growth profile has deteriorated along with those of other power generators. We forecast that the firm adds 270 megawatts of capacity by 2014 as projects in California and Nevada come online. We project concurrent 12.5% annual revenue growth as projects come online at higher power prices, offset by declines from a record top-line year at the products segment in 2009.

Sonic Automotive SAH
Sonic Automotive is undergoing several changes. Over the years, it has altered its acquisition strategy to be more disciplined, has increased its product mix toward the more lucrative luxury and import brands, and is nearly finished installing a dealer-management system across all its stores. These initiatives, along with a promising strategy for increasing used-vehicle sales, make Sonic a solid business, despite the current weak environment for auto sales in the United States.

Our assumptions are for revenue to increase 8.5% on a five-year compound annual basis instead of 7%. We forecast selling, general, and administrative expenses to average 12% of sales. We forecast the operating margin to average about 3.5% during our five-year explicit forecast period.

FTI Consulting FCN
FTI Consulting is known for its market-leading position in bankruptcy, restructuring, and litigation-related consulting services. Its international footprint, highly credentialed consultants, and long-standing customer relationships are its key selling points and create an economic moat around its business.

We believe diversified service offerings, which include a mix of cyclical, countercyclical, and noncyclical business practices, make the firm fairly resilient across economic cycles. FTI is a leading provider of high-end professional services. The company has one of the most respected global practices in restructuring and bankruptcy, and it offers its clients a broad and deep range of services and knowledge. It has developed many long-term relationships with its customers, which can hardly be overemphasized in the consulting industry. FTI derives more than 85% of its revenue from existing customers or referrals from existing clients. Sticky client relationships act as a significant barrier that protects FTI's territory in consulting.

David Krempa is a stock analyst with Morningstar.

David Krempa is an associate analyst with Morningstar.

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