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Stock Strategist

Seeking Moats in the Small-Cap Universe

If they mind the pitfalls, individual investors can get a distinct advantage over large money managers in the small-cap arena.

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I’m excited to kick off a monthly series on small-cap stocks for Morningstar.com. The focus of the series will be identifying smaller firms that exhibit moatworthy characteristics and are run by skillful management teams. This is a promising combination for any company to have, but it’s particularly attractive for smaller companies with long growth runways, as they have the ability to compound shareholders' capital at high rates of return over long periods of time.

Easier Said Than Done
Of course, it’s not a simple task to identify such companies at just the right time. Indeed, there are many "false positives" for enterprising small-cap investors to sort through during their research process. For an illustration of the concept, consider the following examples.

  • A company with significant short-term competitive advantages that may not be defensible in the medium to long term. As such, it may not possess an economic moat. Apparel retailers, for instance, are often found in this category--as fashion trends shift, some firms enjoy a temporary advantage only to lose it when the next trend emerges. A few names that come to mind here are New York & Company (NWY)Christopher & Banks (CBK), and Pacific Sunwear (PSUN)
  • A company that has an economic moat, but whose advantages are slowly being eaten away by able competitors, resulting in less attractive long-term returns on capital. 
  • A company that has exhibited strong growth in recent years or has a valuable franchise, but may be nearing the end of its growth runway, with management struggling to extend it through new product launches. A classic example here is World Wrestling Entertainment (WWE). The company is the undisputed heavyweight in its niche, but scalability is limited, as there are only so many events and products the company can tie to its wrestling franchise. Back in 2000, you may recall, the company tried to launch the "XFL" as an alternative to the National Football League, but the project folded a year later. This speaks to the company's struggles to find new growth runways outside of wrestling.
  • A company that has an attractive business model but is led by poor capital allocators who have consistently made value-destructive investments that limit the company’s long-term potential.  

Any of these four examples could result in a disappointing long-term small-cap investment. As such, a simple screen for stocks that fit certain financial criteria--robust return on equity, profit margins, and so on--isn’t enough, and it’s only the first step in a thorough research process. After all, screening data shows only what happened in the past, and investors of course need to focus on what the future may hold. 

Further, as the head of Morningstar's stewardship methodology, I’m particularly interested in how well small-cap management teams allocate shareholder capital. That’s because, unlike with large companies that require massive expenditures just to move the needle, even modest capital allocation decisions by small-cap executives can have a meaningful effect on a firm’s results. Specifically, we want to identify management teams that are making investment decisions that could establish an economic moat or enhance an existing economic moat. 

Moats and Stewardship Matter
Over the longer term, we think the strength and sustainability of a company’s competitive position within an industry plays a major factor in a stock’s returns, dictating whether the firm is able to consistently generate returns above its cost of capital and create shareholder value. By employing Morningstar’s economic moat framework to our research in this article series, I hope to better separate bona fide opportunities from the false positives that we’d be more likely to encounter without the framework. 

To illustrate, here are four small-cap names that Morningstar analysts have awarded narrow economic moats:


 
Company Star Rating Sector
Cloud Peak Energy (CLD) Basic Materials
Nordion (NDZ) Healthcare
International Speedway (ISCA) Consumer
US Ecology (ECOL) Industrials
Source: Morningstar. Data as of Oct. 8, 2013.

To elaborate on the most undervalued stock of the bunch, we think coal producer  Cloud Peak Energy (CLD) possesses a narrow economic moat derived from a geologically based cost advantage. Cloud Peak owns three large and efficient coal mines in the Powder River Basin, or PRB, in southeast Montana and northeast Wyoming, where extraction costs are extremely low relative to coal mined in central Appalachia. Though U.S. coal stocks have been beaten up over the last five years as low natural gas prices and tougher environmental regulations have curbed demand, we believe that natural gas prices will rise from current levels and that demand for PRB coal will return as utilities are burning through built-up inventories.

Another small-cap company with a narrow economic moat is  US Ecology (ECOL), which possesses a structural advantage related to its landfill assets in the highly regulated North American hazardous waste industry. US Ecology currently owns or exclusively operates four out of 20 actively permitted hazardous waste sites and one of only three "full-service" low-level radioactive waste landfills in North America. Given the political and regulatory opposition to creating new landfills of this kind, as well as US Ecology's track record of handling such dangerous materials, we do not believe newcomers can easily replicate US Ecology's business model. 

As Warren Buffett wrote in the 1994 Berkshire Hathaway shareholder letter, "Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value." If we can identify small firms that possess durable competitive advantages, have healthy financials, and are headed by skillful capital allocators, then we might just find a few companies that can generate significant long-term returns given their ability to compound shareholders' capital at a high rate.

Each of the four firms highlighted here have been awarded Standard Stewardship Ratings by Morningstar analysts, meaning that for each firm, management's capital allocation decisions in recent years have had a net neutral effect on shareholder value. The ideal combination is a firm with an economic moat and Exemplary Stewardship--a rare combination, indeed--but these five firms would certainly not be considered "false positives" and are attractive small-cap ideas at the right price.

A Worthy Journey
Despite the potential pitfalls of small-cap investing--the extra share price volatility, companies with less access to the capital markets, and so on--an individual investor with a long time horizon, a calm demeanor, and an eye for finding well-run businesses can have a distinct advantage over large money managers in this arena. One reason is that institutional investors are limited in their ability to purchase meaningful stakes in a small company without affecting the company’s stock price or taking an unwanted large ownership position. Another reason is that because institutional investors and analysts naturally pay less attention to the small-cap space, there’s more opportunity for individual investors to exploit potential mis-pricings. In other words, individual investors should look to exploit their small-cap advantage when it's appropriate to their financial plan.

I’m looking forward to highlighting some hidden gems in the small-cap space, and I hope you find the series a valuable addition to Morningstar.com's regular features. Finally, I want to make this an interactive feature, so I encourage you to add your questions, comments, and feedback in the comments section below. 

Todd Wenning does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.