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By Jeremy Glaser and Todd Wenning, CFA | 10-02-2014 11:00 AM

After Taking It on the Chin, Some Small Caps More Attractive

A recent sell-off is starting to create opportunities for long-term small-cap investors, including these two names, says Morningstar's Todd Wenning.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Small-cap stocks have taken a beating recently. I'm here with Todd Wenning, an equity analyst here at Morningstar and also the author of our Seeking Small-Cap Moats series.

Todd, thanks for joining me.

Todd Wenning: Thanks for having me.

Glaser: Let's look at the performance that small caps have had. Why do you think they've been underperforming and in correction territory versus their larger peers?

Wenning: It's always hard to say exactly why a group of 2,000 stocks do one thing or the other, because some of them are doing well still and some of them are struggling. But overall, small caps have clearly been taking it on the chin. A lot of times small-cap stocks will lead large caps out of recessions and then into recessions. They are more volatile in general.  When there is a "risk-off" trade--which I think we're seeing around the world with geopolitical tensions, the scares of Ebola, weak consumer numbers yesterday--there are a lot of things that are scaring investors.

Glaser: The Russell 2000 is now in correction territory. Has this opened up any opportunities? Is there now a pocket of value in a market that's looked pretty expensive?

Wenning: If you're trader, this is a very unfriendly environment. If you're a long-term small-cap investor, this is an exciting opportunity, because things are starting to get a little better. I don't think you can throw a dart at a page of small caps and come out ahead. I think you do have to be very selective. I do think you are seeing more and more stocks coming down from overvaluations and getting closer to fairly valued. You're getting close to more opportunities to make more purchases.

Glaser: What kind of attributes are you looking for in small caps that you might want to be looking at now?

Wenning: The first thing I look for is, does the company have a durable competitive advantage? We call them "moats" here at Morningstar, of course. I don't want to look for a company that has very commoditized products. I like to find companies that have very strong niches. I want to find companies also that have strong management, a good capital-allocation discipline, that have invested in the business that they own--at least  a few percentage points of the overall business. In addition, I like to see companies with very good balance sheets, so they can endure some of the tougher times, and invest when everyone else is scared.

Glaser: Are you looking to buy any firms like that right now?

Wenning: We've highlighted 11 companies in the Seeking Small-Cap Moats series. There are two companies that are particularly interesting. In fact, I've actually purchased them myself over the past month, in full disclosure.

The first one is WD-40, which makes the lubricant product that we all know and probably have in our house or garage. The company has come down a little bit, but I think its economic moat is, in my opinion--we don't cover them, so this is just my opinion--very strong, because they have a very strong brand across the world. My long-term thesis on the company is that, as emerging-markets per capita incomes increase, they'll buy more durable goods, more things will need to be repaired and maintained. That's a strong tailwind for WD-40. So, I think the stock looks really attractive right now.

Glaser: What's the second name that you bought?

Wenning: The second name is Raven Industries. This is a company that's down about 40% year to date. It's primarily an agriculture-based company. In the last year or so, corn prices and wheat prices have been very low, and that's causing concern about farmer incomes and how much they're willing to spend on agricultural equipment. Raven makes precision agricultural equipment. They basically help farmers increase their yields. But when prices are low, farmers aren't going to want to increase their yields. They're going to want to maintain as much as they're producing. That's one of the reasons the company is down a bit.

They're also going through a transformation right now in terms of how they handle contracts and what kind of business that they do. So a lot of things are coming together [against them] right now, but I think the company is a very strong performer. They just raised their dividend even though they had a very rough year. And I think their long-term prospects look very good.

Glaser: Todd, I certainly appreciate the update today.

Wenning: Sure. Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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