Finding the Ugly Duckling: Undervalued Small Caps with High Potential

It is generally accepted among stock investors that investing in Big Cap companies involves less risk. On the other hand, investing in small cap companies is usually considered to be more risky and volatile. Although this is not a misconception, there are many investors who are shifting their attention from big cap companies to small cap companies because many insightful investors are now aware that investing in small cap companies can generate more profits in the long run than investing in big cap companies i.e most blue-chip stocks. The characteristic of a small cap company is that it usually deals with unique products with high price elasticity, and attracts individual investors because it allows small cap companies to perform well in both high and low inflation.

In the last decade, the performance of small caps exceeded that of big caps, meaning that investing in small caps increased one’s chance of generating more profits. However, it is true that small cap stocks involve more risk than big cap stocks. Many small cap companies declare bankruptcy every year, resulting in huge losses of numerous individual investors. Then, what should individual stock investors be aware of, in order to avoid risk while investing in small cap stocks?

The first thing to keep in mind is that one should look for small cap stocks that are currently undervalued. If an investor is only interested in stocks that are currently performing extraordinarily, their chances of growing and generating profits are not that high because those stocks would have already been monitored by numerous other analysts and investors. On the other hand, currently undervalued stocks would not attract a lot of other investors, giving the investor more potential for performing above average and generating more profits. If this is a given, what would be the most important criteria when selecting such undervalued stocks? There are three major variables to look at; Return on Equity (ROE), Debt to Equity, and Current Ratio.

The Return on Equity (ROE), which shows the profit a firm generates with the money shareholders have invested, should be above 15 percent. 15 percent is the generally accepted level of ROE that indicates high profitability. The Debt to Equity ratio, which reveals how much a company relies on outside capital for growth, should be lower than 0.5. This means that a company does not rely too much on outside capital, resulting in fewer risks. Finally, the Current Ratio, which is an indication of ability of firms to pay their short term obligations, should be higher than 2. However, these criteria are not enough when selecting undervalued small cap stocks with few risks and high profitability.

The other aspect to look at is the health of the structure of the undervalued companies. Stocks that are currently undervalued can have potential to grow in the near future; however, the undervalued stock becomes ‘garbage’ without healthy internal structures that can actually lead to growth. Hence, it is important to analyze their industry sectors, debt levels and management system in order to select undervalued stocks with few risk and high profitability.

The industry sector of a given company is extremely important because it can determine whether the company will be able to generate high profit consistently or not. It is better to find industry sectors that have high potential to grow in the near future, such as renewable energy, resources fabrication, IT technology, display technology, and specialty retails. Furthermore, the debt levels of a company should ideally be low, because a company with a high debt level has more potential to become bankrupt. Finally, the management system of the company should be competent and transparent.

Under these criteria, there are three remarkable small cap stocks in America that are currently undervalued.

Company #1: SMCI (Super Micro Computers INC)

 

Market Cap: 1.13B        ROE: 19.40%           P/S:0.77           Debt to Equity: 0.10              Current Ratio: 2.1

SMCI is known as an End-to-End Green computing solution provider. They specialize in solutions for HPC, Data Center, Cloud Computing, Enterprise IT, Hadoop/Big Data and Embedded Systems worldwide. SMCI was firstly founded in 1993 by Charles Liang, current President, CEO and Chairman of the Board. Charles Liang had devoted himself to the development of server system architectures and technologies. The management system seems transparent as they make public many documents about corporate governance, including Charter of The Audit Committee of the Board of Directors, Charter of the Nomating and Governance Committee of the Board of Directors, Charter of the Compensation Committee of the Board of Directors, and Code of Business Conduct and Ethics via their website.

Their technologies that make them unique from other technology solution firms involve innovative system architecture, such as FatTwin and SuperWorkstations etc. FatTwin is a type of SuperServer solutions that expands compute and storage capacities which allows increased performance with lower power consumption. SuperWorkstation is a Tower-based computing solution that is optimized for applications in digital entertainment, such as scientific and engineering design, video film editing and image processing. Further, these technologies support their motto of ‘Green Computing’, which is another factor that discerns SMCI from other tech firms. Their aim is to produce cost-effective and energy-efficient Green IT products. Their concern to decrease power consumption while increasing efficiency, matches the global economic trend which focuses on energy conservation technology with high-efficiency. Also, their efforts are creating visible results which involved a decrease of the TCO (Total Cost of Ownership) of SMCI servers and systems. They were also able to increase the traditional efficiency level of systems from 80 percent to 95 percent. For instance, their 4U FatTwin technology enables one to reduce power consumption up to 16 percent.

SMCI’s future prospect is quite positive, not only because of its unique technologies and motto of green computing but also because of the fact that they are in process of globalizing their business. Their products are being exported to all continents of the world. They also have offices in East Asian countries such as China, Taiwan, and Japan where the demand for such technology is extremely high. Hence, the worldwide demand for the products of SMCI looks like it will increase in the near future.

 

Company #2: TBI (True Blue INC)

Market Cap: 1.11B         ROE: 15.80%           P/S:0.63           Debt to Equity: 0.07             Current Ratio: 3.1

TrueBlue is a recruiting and workforce management company which sends as many as 100,000 unemployed workers to work every day and also gives employment opportunities to 250,000 people annually. Using a data base of thousands of available candidates, the company receives requests from its clients from various industries and allocates those with the necessary labor skills to the demanded positions. Its name was acknowledged on Forbes’ 100 “Most Trustworthy Companies” for its solid corporate governance and accounting transparency. TrueBlue headquarter is now located at Tacoma, WA, and is traded on the NYSE.

The current CEO of TrueBlue, Mr. Steve Cooper, is proud to announce this business as a growing and ambitious industry leader. Starting from a small office in Kent, WA, in 1989 to a $2 billion  business, the company has kept its steadfast purpose of “putting people to work” to change the lives of both its candidates and clients for the better. Mr. Cooper’s leadership has led the company to partner with diverse clients to aid in the findings of specialized solutions to their specific needs, ultimately aiming for the growth of their businesses. Another key figure in the company is Mr. Joseph P. Sambataro, Jr., who has been serving as the Chairman of the Board since 2008. Prior to his position, he was appointed as the CEO of TrueBlue from 2001 to 2006, and also served as the CFO from 1997 to 2001. His early hands on experience as the CEO and CFO, together with his leadership and coaching skills, financial and accounting expertise, qualifies him as an appropriate and qualified Chairman. Other influential figures include the directors – Thomas E. McChesney, Gates McKibbin, Jeffrey B. Sakaguchi, Bonnie W. Soodik, William W. Steele, and Craig E. Tall – and the Executive Vice Presidents – Kimberly A. Cannon (Human Resources), James E. Defebaugh (General Counsel), and Derrek L. Gafford (Chief Financial Officer) – who comprise the backbone of this business.

TrueBlue’s strongest feature is that it listens to its clients’ different goals and needs, and finds personalized workforce solutions that are adjusted to meet personal demands. It can create a team of workers in no time and position them in different industries in North America quickly and easily. The company’s competitive advantage is its specialized knowledge in diverse areas of many industries through interactions with clients from all kinds of businesses. Awareness in various fields, including their regulations and compliance issues, means that the company knows the right skills to exploit at the right time for every client, reducing the risk of mismatching the demands and the solutions. Some of its specialties include: handpicked reliable workers in manufacturing and logistics ready for on-demand temporary employment for jobs in construction, warehousing, etc.

Thus, TrueBlue provides a quite unique niche of service that can be considered as a ‘blue ocean’ in today’s industry. Their service of innovative recruiting and workforce management makes the future prospect of TrueBlue positive, as they have a lot of room to expand and grow, not only throughout the USA, but also throughout the whole world.

 

Company #3:MLI (Mueller Industries)

Market Cap: 1.62B         ROE: 16.10%           P/S:0.72           Debt to Equity: 0.35             Current Ratio: 3.5

Mueller Industries is a company that produces Flow Control and Industrial Products. They specialize in the manufacturing and distribution of copper tubes and fittings. Their stocks is publicly traded on NYSE under the ticker  MLI. Their major target involves wholesalers, retail distributors and original equipment manufacturers, offering them flow control and industrial products.

The Board of Directors of Mueller Industries includes Gary S. Gladstein, who is the Non-Executive Chairman of the Board, and Gregory L. Christopher, who is serving as the Chief Executive Officer of Mueller Industries. The management system of Mueller Industries also seem transparent and trustworthy, as they disclose information about corporate governance, including their Compensation Committee Charter, Nominating and Corporate Governance Committee Charter, and Audit Committee Charter. Furthermore, they post Anti-Corruption policies on their website that deal mostly with the types of bribery that are forbidden in their industry, indicating that their management and investment is being done transparently.

Their products include tubes, pipes, metal fittings, plastic fittings, and valves that are needed for plumbing. Furthermore, they provide many services that cover almost all section of plumbing, engineered solutions, and refrigeration. Thanks to the variety of products and services they provide, the demand for products of Mueller Industries seems like it will be consistent in the future.

These three are only the tip of an iceberg in terms of undervalued stocks. There are many other undervalued small cap stocks not only in the US, but also abroad. However, one thing to remember is that not all currently undervalued stocks will be properly valued in the near future. Some might take one year, another might take five years, and some other will not be valued properly forever. It is necessary to perfectly understand the firm itself; its financial statement, legal statement, business in details,and  prospective trend of its industry. Furthermore, the investor also needs to be aware of the trend of the economy in the larger sense, not only the trend of the industry sector of the firm one is investing in, but also other related industry sectors and how they are going to change. Thus, in order to find the ugly duckling that might become a swan someday, the investor needs to see both the forest and the wood.

 

 

Works Cited

Kraakman, N. (2013, July 08). How to Find Undervalued Stocks in 3 Simple Steps. Retrieved from Value Spreadsheet: http://www.valuespreadsheet.com/value-investing-blog/how-to-find-undervalued-stocks-in-3-simple-steps

Lord, M. (2014, 6 27). 5 Undervalued Small Cap Stocks Yielding High Dividends. Retrieved from TREFIS: http://www.trefis.com/stock/efc/articles/245052/5-undervalued-small-cap-stocks-yielding-high-dividends/2014-06-27

Vodicka, M. (2013, 10 23). 7 Undervalued Small-Cap Stocks Crushing The S&P. Retrieved from Street Authority: http://www.streetauthority.com/7-undervalued-small-cap-stocks-crushing-sp-30420150

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“TrueBlue | Specialized Workforce Solutions.” TrueBlue | Specialized Workforce Solutions. N.p., 2014. Web. 14 Aug. 2014

Mueller Industries – World Leader in Flow Control and Industrial Products for Over 90 Years.” Mueller Industries – World Leader in Flow Control and Industrial Products for Over 90 Years. N.p., n.d. Web. 14 Aug. 2014.