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Stock Strategist

Seeking Small-Cap Moats: Annual Review

Morningstar's Todd Wenning takes a look back at the small-cap stocks featured over the past year.

Last October, we kicked off a monthly series focused on identifying small-cap stocks with potential economic moats and have since profiled 11 companies. With a full year now behind us, let's have a look back at the stocks we've profiled and see where they stand today.

Letting Off Some Steam
Though the main objective of this series is to uncover some lesser-known small caps with competitive advantages, not to be a stock-picking service, the articles are naturally more fun for both the reader and the writer when the profiled companies also appear to be attractively priced at the time of publication.

For much of the past year, however, this wasn't the case--the Russell 2000 Index reached its peak in early July--and many of the companies we profiled looked fully valued at best.

While the market's recent volatility has made the small-cap market a tricky one for traders, for investors with a long-term mindset it has presented opportunities to revisit some ideas that looked overvalued a few months ago. Here's how the 11 stocks we've profiled have fared, presented in order of publication.

With the benefit of hindsight, taking a patient approach has generally been prudent when considering these companies for investment. Indeed, I took advantage of a few pullbacks in my personal account, having invested in WD-40 in late July and in Raven Industries earlier this month. While I don't plan to purchase every stock profiled in this series, I do like to put my money where my mouth is when the opportunity presents itself. (Note: I always wait at least two trading days after mentioning a company in an article before buying it in my own account.)

Company Updates
Here are my current thoughts on the 11 companies we've profiled so far.

John Bean Technologies (JBT) - I continue to like JBT's meaningful recurring revenue stream and the mission-critical nature of its food processing equipment. At its investor day in May, management laid out some fairly optimistic medium-term revenue and operating margin targets that I think will require some skillful acquisition and integration work on the part of the relatively new executive team. Given this tall order, I'd like a little more margin of safety before considering an investment.

Culp, Inc. (CFI) - The mattress and upholstery fabrics manufacturer has a balance sheet stuffed with cash, ending its fiscal first-quarter 2015 with a net cash position near $26 million. Even after increasing capital expenditures to expand its mattress fabrics operations and build working capital, the company expects another "good year" for free cash flow. I continue to be impressed by management's capital-allocation decisions--including a $0.40 per share special dividend and round of buybacks in the first quarter--and I think investors should get to know this company.

Badger Meter (BMI) - Last week, Badger Meter announced record quarterly revenue and earnings per share on the back of strong municipal water product sales. As we discussed in the original article on Badger Meter, new product adoption tends to occur slowly in this industry, but Badger Meter's new meter-reading system launched in 2013 has begun to build traction in important markets. The stock still looks fully valued near $50 a share on Friday, and I'd look to start a position in the mid-$40 range.

US Ecology  - In April, the hazardous-waste specialist acquired the Environmental Quality Company, which added a Michigan-based hazardous waste landfill to U.S. Ecology's disposal capacity, further expanding the company's geographic reach east of the Mississippi River. Our analyst, who has a $41 per share fair value estimate on US Ecology, thinks the deal supports our wide economic moat rating.

Sun Hydraulics (SNHY) - The manufacturer of high-performance screw-in cartridge valves and manifolds remains one of my favorite small caps due to its switching cost advantages, exemplary management team, and strong corporate culture. I thought the shares were expensive back in March when they were trading above $40 per share, but I'd be happy to add to my current position below $35 per share.

Exponent (EXPO) - This engineering and scientific consulting company's strong reputation and the frequent demand for its services (helping clients with high-exposure litigation, insurance claims, product recalls, and so on) have produced very steady profits over the past 10 years. Perhaps unsurprisingly given these steady results and the company's sterling balance sheet, Exponent's stock typically trades at a premium to the market average and rarely looks cheap. I'd look to buy Exponent below $65 per share.

Raven Industries  - With the stock down 40% year to date, it's safe to say Raven's had a tough year. Contributing to the market's sour mood toward the stock are lower corn, soybean, and wheat prices, which will likely mean lower farmer incomes and reduced spending on precision agriculture equipment. While the market's short-term concerns are legitimate, I think this could simply be a bad year or two, and the company is still well positioned for longer-term success. With limited arable land across the globe and growing emerging-market food demand, I expect that crop yields will need to increase in the longer term, which should provide a steady tailwind for Raven's precision agriculture equipment.

WD-40 Company (WDFC) - Like Exponent, WD-40 is a stock that generally trades at a premium to the market, and it's a premium that's well-deserved. I think the company has a very strong intangible-asset-driven economic moat, anchored by well-known brands that provide it with pricing power at the consumer level and make it a valuable partner for retailers who know that its products will help drive traffic to their stores. Management anticipates 8%-9% earnings-per-share growth in fiscal 2015, which could be even higher if oil prices remain low (petroleum-based products are a key input cost).

Douglas Dynamics (PLOW) - Thus far in 2014, just about everything has been working in the snow plow specialist's favor. A snowy winter in North America, strong U.S. light truck sales, and improved dealer and consumer sentiment all contributed to record quarterly revenue and earnings per share in the second quarter. I'm always cautious about buying a stock when its business is firing on all cylinders because there's a good chance other investors are extrapolating the recently strong results, and the stock is consequently priced to perfection. I'd look to start a position below $16 per share.

Winmark (WINA) - CEO John Morgan is an impressive capital allocator and uses the steady cash flow from Winmark's retail franchises to reinvest in high-margin equipment leasing operations. One of my lingering concerns is what happens if the cash flows from Winmark's brick-and-mortar retail franchises dry up as a result of increasing online competition, including competition from newer sites that also specialize in lightly used merchandise. Second, the U.S. National Labor Relations Board has recently issued some negative opinions about the liability of franchisors toward employees hired by their franchises, claiming that the parent company is a "joint employer" and thus has shared liability on a variety of issues that previously resided solely with the franchisee.

Latchways  - The U.K.-based manufacturer of fall protection systems issued a profit warning on Oct. 7 due to delayed capital projects in the European market. The stock price fell sharply on the news and now trades around GBX 750, well below the GBX 950 level that I originally considered a good entry point, and nearly 50% below its 52-week high. While the lower price could mean the stock is on sale, I do have concerns about the company not increasing its dividend despite what management called "temporary" challenges. To me, that could be sign that management and the board aren't altogether confident in medium-term prospects and that the challenges may not be temporary.

Favorite ideas
As of Oct. 17, here are my top five watchlist candidates (in no particular order):

  • Winmark: More research is needed on the threat of online competition and potential changes to franchisor liability.
  • Raven Industries: The current price looks attractive, but the biggest risk is that we're only now entering a long downcycle in farm-equipment demand.
  • Latchways: Despite new concerns, the stock price has fallen enough to make it worthy of further research.
  • Sun Hydraulics: I think this is one of the best-run companies in America. Buy it for a good price and then be patient.
  • US Ecology: In the event of a broader market pullback, it's hard not to like this wide-moat small cap as a long-term investment.

I hope you've enjoyed reading the series as much as I've enjoyed writing it. Thanks very much for your interest and for your feedback over the year. The next article in this series will be published on Wednesday, Nov. 26.

*Todd owns shares of Sun Hydraulics, WD-40 Company, and Raven Industries.

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