Small Companies Play Big Role In Prize Winner's Strategy; Maybe For You, Too?

Includes: AIRI, TIS
by: Ron Stewart

(Editors' Note: This article covers micro-cap stocks. Please be aware of the risks associated with these stocks.)

Small- and micro cap stocks, although risky, deserve a position in a retiree's income portfolio. I've recently added two small-cap stocks and am happy I've done so.

Renowned economist Dr. Eugene Fama knows something about the markets. After all, he's studied them for years. And for his work, he was given the Nobel Prize in Economics last month, an honor he shares with two other economists, with whom (notably) he does not agree.

Reading about the three of them recently, I feel even more strongly that searching for small companies with potential for both dividend and value growth is worthwhile.

Here's the interesting thing about Dr. Fama's work: He argues that individual investors have little chance of forecasting market movements. Instead, he says, market pricing -- whatever it may be at a given moment -- already has factored in the best available information.

(For an interesting commentary on Dr. Fama's work from one of the other Nobel Prize winners, Dr. Robert Shiller, click here.)

But here is the second thing about Dr. Fama's work: He is the brains behind a successful money management company that by most accounts routinely beats the market. How? Put simply, he urges weighting portfolios with well-priced small companies.

When I put together my 2013 business plan I wanted to expand holdings in my Dividend Investment Project to between one dozen and two dozen holdings. Keeping with plan, I added one company recently added, and a second was added in the spring and has performed remarkably. These two companies are worth a look.

A small-cap with a big showing

The first is Orchids Paper Products Co. (NYSEMKT:TIS), which makes and sells tissue products for the at-home market in the United States. Its products, including bathroom tissue, paper towels and paper napkins, are sold at so-called "dollar" stores, discount retailers, grocery stores, grocery wholesalers and cooperatives, and convenience stores.

I've written about this company before; you can read the earlier article here.

About the only thing that's changed since I wrote about it last spring is the remarkable performance of Orchids Paper Products. That and its share price TIS' currently trading in the $30.05 / share range, an impressive 33% appreciation since April 1.

What's more the company increased its June 5 dividend to 35 cents a share, a whopping 16.5% jump from the 30 cents previously paid.

Based on what? How about record sales and profits? In July the bullet item list from the company's news release was this:

  • Established a new quarterly record for both total net sales and converted product net sales of $29.2 million and $27.8 million, respectively.
  • Converted product shipments were 2,080,000 cases, exceeding the prior record of 1,864,000.
  • EBITDA in the second quarter of 2013 was $6.4 million, an increase of $1.4 million, or 27%, over the prior year quarter.
  • Second quarter 2013 net income was $3.1 million, an increase of $906,000, or 41%, compared with $2.2 million of net income in the same period of 2012.
  • Diluted net income per share for the second quarter 2013 was $0.39 per diluted share compared with $0.29 per diluted share in the same period in 2012.

In October, it sounded almost the same, only better:

  • Established a new quarterly record for EBITDA of $6.9 million.
  • Established a new quarterly record for both total net sales and converted product net sales of $29.8 million and $28.2 million, respectively.
  • Converted product shipments were 2,096,000 cases, exceeding the record set in the second quarter of 2013 of 2,080,000.
  • Third quarter 2013 net income was $3.7 million, an increase of $1.4 million, or 60%, compared with $2.3 million of net income in the same period of 2012.
  • Diluted net income per share for the third quarter 2013 was $0.47 per diluted share compared with $0.29 per diluted share in the same period in 2012.

Management's view of the future, available in its 10-Q report, is that its sales of paper products is likely to increase, its sales of parent roll (non-converted) paper rolls from its paper-making facility are likely to decrease (because it's pushing its paper making facility closer to capacity) and its margins will likely improve, because converted product is more profitable than sales of parent rolls.

Summary for TIS:

For the near term things look good at Orchids Paper. It has a solid and growing niche in the low-cost, value-oriented home paper products market. Does its current price in the neighborhood of $30.50 a share (just off the 52-week high, by the way) represent a buying opportunity? The present price affords a 4.5% yield, and that's attractive to many investors. My guess, however, is that Prof. Fama's "efficient" market will think the current price is a little aggressive. The better bet will be to accumulate shares at something closer to $27.50 a share.

How about a micro-cap?

The second company is Air Industries Group (NYSEMKT:AIRI). This company designs and manufactures structural parts and assemblies that focus on flight safety. Its products are used on a range of military and commercial aircraft. It serves prime contractors, aerospace engine manufacturers, other subcontractors to aerospace manufacturers, original equipment manufacturers, members of the defense and commercial aerospace industry supply chains, and the U.S. and foreign governments.

It is a very small company, and its shares trade very thinly, some days not at all. The company should be viewed as a long-term investment, if for no other reason than that it would be difficult to sell a large number of shares quickly at a reasonable price.

In October, however, it got deserved attention when it doubled its dividend to 12.5 cents per share from 6.25 cents per share. It traded at the end of October at $7.75 per share, meaning that its 50-cents-per-share annual dividend amounts to a 6.4% yield.

The attractive dividend comes with risk. It's no small matter that much of the company's customer base is defense related, and memories of congressional episodes of self destruction are not distant. However, it recently announced that it had secured another contract, this one covering several years and worth about $27 million -- very significant for a small company.

Debt is high at 125% of shareholder equity, and free cash flow will be much closer to dividend payout with the increased dividend, unless revenues increase. Still, free cash flow at present suggests the company can sustain its attractive dividend.

To be sure, management recently noted that the company's debt has been reduced by $2.5 million. Said board chairman (and major shareholder) Michael Taglich, "Our Board is increasingly confident in the Company's position and we plan on paying annual dividends of $0.50 a share -- in quarterly installments -- as a matter of policy, so long as it is prudent and possible to do so."

The pledge of sustained high yield is wonderful, but, of course, the qualifier ("... so long as it is prudent and possible ...") is where the risk lies.

The company is growing, however, in part because it is acquiring related enterprises such as Decimal Industries, a leader in precision sheet metal fabrication. The future is looking brighter for AIRI.

Summary on AIRI

Prof. Fama's efficient market, as evidenced by the recent price, apparently likes the prospects. I do, too, and have added shares at a cost in the $7.90 range. This price certainly is no present-value bargain, but there may not again be opportunity in the $6 per share range, when congressional bluster and brinkmanship was all the news. My money is on a brightening longer term.

Interestingly, both of these companies have ties to Taglich Brothers, a New York based brokerage firm that specializes in micro-cap opportunities. As noted above, Michael Taglich is AIRI board chairman.

Investors wanting to selectively add small dividend-paying companies to their portfolio may want to give AIRI a close look.

Disclosure: I am long TIS, AIRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that the information presented here is not the work of licensed financial adviser or experienced investment professional. Information provided should never be construed as investment advice. It is for educational and informational purposes only, and constitutes the elements of a personal learning project.