As I wrote in February, new highs in the stock market may give the sense that investors have missed the opportunity to buy solid growth companies at a discount. However, even as many stocks approach 52-week and all-time highs, there are plenty of bargains out there.
These small caps are worth a look
To take a more growth-oriented spin on the stock screen used in February’s article, today’s screen features a population of small cap stocks with a PEG ratio less than 1.0 and a five-year estimated earnings growth rate of at least 20%. Among the population of over a hundred stocks that meet these criteria, here are several noteworthy companies worth consideration.
Trex Company, Inc. (NYSE:TREX), the provider of premium and eco-friendly decking and other materials for outdoor living spaces, has a number of drivers behinds its projected 20% growth rate. These drivers include the housing recovery, growing focus on outdoor living, use of recycled materials, and synergies from a series of acquisitions. As concluded in a recent article on housing related stock ideas, Trex is a compelling stock given its numerous growth drivers and attractive valuation from both a free cash flow yield and PEG perspective. The company’s most recent quarterly results set new records for the company and beat analyst expectations; this combination shows the strength behind the investment thesis for Trex Company, Inc. (NYSE:TREX) going forward.
Sodastream International Ltd (NASDAQ:SODA) continues to grow at a rapid pace as it expands its footprint into new geographic markets, expands its distribution through new sales channels, and partners with well-known brands ranging from Ocean Spray to Kool-Aid.
After years spent recovering from the one-two punch of an accounting scandal and being over-extended as a result of an overly-ambitious expansion plan, Krispy Kreme Doughnuts (NYSE:KKD) is back on track with expected growth of 25% annually. In the past few years, management’s strategy for disciplined growth combined with the passage of time putting the company’s issues farther in the rear-view mirror have led the stock to new highs that haven’t been seen since the dramatic fall of the company almost a decade ago:
Even with the trend towards healthier eating, it is hard to argue with the appeal of the “hot now” sign!
A lesser-known company to consumers on this list is Liquidity Services, Inc. (NASDAQ:LQDT), a creator of online marketplaces for a range of surplus and scrap items from government and industrial sources. The company operates a growing portfolio of marketplaces that boast over 40 million visitors per year. After a tremendous performance over the past several years, the past year or so has brought the company’s stock price downward as concerns regarding future growth and acquisition integration have surfaced. Still, the long-term growth story remains intact for those investors that believe in the company’s ability to become the eBay of government salvage. This long-term goal is of course predicated on the continued patronage of large government clients such as the Department of Defense; the scrap contract with the DoD accounted for 27% of Liquidity Services, Inc. (NASDAQ:LQDT)’s revenue last year, and presents a definite risk concentration.
Pegasystems Inc. (NASDAQ:PEGA) operates a niche software business with expertise in business process automation and tracking software. Through partnerships with a wide range of consulting firms such as Accenture Plc (NYSE:ACN), Pegasystems provides custom software solutions to meet the specific needs of its clients in a wide range of industries. The ability to address the highly-specific needs of a process that is unique to a particular company or industry is something that software giants like SAP AG (ADR) (NYSE:SAP) have largely ignored thus far; this lack of interest has provided Pegasystems Inc. (NASDAQ:PEGA) with the ability to build a market-leading position in a number of industries. The company just announced its quarterly results Monday evening; while top-line growth appears anemic at just 5%, this is largely a reflection of the ongoing shift in product mix from professional services (which declined 17% due largely to macroeconomic conditions) to software licensing, which grew 20%. A 124% increase in net income for the quarter shows just how strongly the business is performing.
Which stock to buy?
Here is a look at each of these small-cap companies by the numbers:
| TREX | SODA | KKD | LQDT | PEGA | |
|---|---|---|---|---|---|
| CAPS rating (out of five stars) | 4 stars | 2 stars | 2 stars | 5 stars | 3 stars |
| Stock price | $52.70 | $54.98 | $13.00 | $33.08 | $26.05 |
| Market capitalization (in millions) | $905 | $1,119 | $850 | $1,104 | $988 |
| TTM P/E ratio | 75.83 | 26.31 | 43.33 | 27.29 | 36.77 |
| Analyst expected five year growth rate | 20.0% | 30.5% | 25.0% | 22.5% | 25.0% |
| PEG ratio per Yahoo! Finance | 0.87 | 0.70 | 0.86 | 0.78 | 0.84 |
| TTM free cash flow yield | 3.5% | 0.3% | 5.3% | 1.5% | 9.6% |
| Debt to equity ratio | 0.62 | 0.00 | 0.10 | 0.0 | 0.0 |
| Source: Motley Fool CAPS and Yahoo! Finance – May 6, 2013 | |||||
On the surface, it would be easy to argue that none of these companies look particularly attractive based on trailing twelve month results. Other than Pega’s 0.5% dividend yield, none of the companies listed above pay a dividend either. However, it is important to consider a number of factors prior to rushing to judge a small cap based on trailing metrics.
For example, Trex’s record first quarter results also include short-term negative effects from the company’s “early buy program;” this program incentivizes Trex re-sellers to stock up on Trex materials to ensure adequate stock for the peak deck-building season; the incentives offered include discounts and favorable payment terms. This is a common practice in the industry and no reason for long-term concern, but it temporarily contributed to a $90 million increase in accounts receivable and $67 million increase in borrowings during the first quarter. The impact of this program has historically evened out during the year as cash is received and used to pay down debt.
Meanwhile, Sodastream International Ltd (NASDAQ:SODA) continues to invest heavily in its expansion into the United States and elsewhere in the world, resulting in minimal free cash flow generation as the company continues to drive revenue growth. As noted above, Pegasystems is facing top-line pressure as service revenue is facing double-digit declines as a result of IT spending cuts around the globe. Whether it is seasonality, investment in the future, or withstanding a tough IT spending environment, these companies are all continuing to build on formidable positions in their industries that are even stronger than trailing data may indicate.
For investors looking to make a long-term investment, a solid thesis can be made that each of these five companies has a good chance of beating the market given the expectation that each can grow earnings by at least 20% annually. It is important to remind anyone thinking about purchasing shares that small caps are quite volatile; there will be sharp ups and downs along the way, so patience and a long-term mentality are required. Additionally, small caps typically have elevated risk; for example, the loss of the DoD scrap contract by Liquidity Services would be devastating to the company’s growth plans (and stock price).
For my money, Trex and Sodastream International Ltd (NASDAQ:SODA) make the best case for long-term investment based on the sizable market opportunity and exposure to larger trends in consumer spending.
The article 5 Small Caps That Are “PEGged” for Success originally appeared on Fool.com and is written by Brian Shaw.
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