Winning Small Caps

By Sham Gad | March 14, 2012 AAA

So far in 2012, small caps have underperformed the overall market. Based on the iShares S&P SmallCap 600 Index (NYSE:IJR) return of 7.8%, the small cap index is ahead of the S&P 500 by nearly 0.5 percentage points. Despite the solid start to the market in 2012, investors have prudently followed the path of quality larger stocks, instead of seemingly riskier smaller-cap stocks. Yet sometimes, better opportunities come in smaller packages for patient investors.

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Hidden Gems
Nature Sunshine Products (Nasdaq:NATR) manufacturers and distributes nutritional supplements and personal care products worldwide. The company sells directly to independent distributors and managers, who then resell them to other distributors or consumers. As a result of this approach, the company enjoys healthy margins and return on capital. The company has no net debt and enjoys a return on equity of over 20%. The company generates attractive cash flows and trades for about 9 times forward earnings. (For related reading, see How Return On Equity Can Help You Find Profitable Stocks.)

The auto parts industry is firing on all cylinders, thanks to aging cars that require more parts and service as they get older. While most investors see that business is booming at AutoZone (NYSE:AZO), the largest auto parts retailer in the U.S., small cap Dorman Products (Nasdaq:DORM) is also climbing higher. This $840 million market cap seller of nearly 130,000 automotive replacement parts, supplies the likes of AutoZone and other auto parts retailers and warehouses, with the necessary parts. Despite a share price that is up nearly 33.5% in the past year, shares trade for 11 times forward earnings while sales are growing by 16% and earnings by over 15% from 2010 to 2011, respectively.

Small Cap, Big Yield
Not many would associate a 5% yield from a company with a $230 million market cap. That is exactly the case with online pet pharmacy PetMed Express (Nasdaq:PETS). Shares trade for $11.70 and shareholders receive a 60 cent dividend every year. With no debt and over $50 million in cash on the balance sheet, the dividend seems safe for years to come.

PetMed is also the only pure play online retailer of pet products, making the company an attractive acquisition for a giant like Amazon or big box pet retailer PetSmart (Nasdaq:PETM), as an attractive way to enter the online pet market. Pet owners continue to spend more on their pets and online shopping continues to grow. At the current share price, the market is not giving PETS any valuation for future growth. If a potential buyer sees the growth opportunity, they will likely bestow a premium on the shares.

The Bottom Line
While larger companies are perceived as safer investments, today's small cap companies have the potential to be tomorrow's bigger giants. They also provide larger competitors with an opportunity to acquire additional growth or expansion into attractive markets. Safety in investing comes from valuation, not from size.

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At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.

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