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"Safe Small-Caps" kind of seems like an oxymoron. Usually these companies come with higher risk, yet higher reward. But, sometimes there are small companies that run steady business that are just too small to be appreciated by investors. I have compiled the list below with small-cap names that I not only believe have significant upside, but also have fairly small relative downside due to company specific reasons and the industries each company competes in. I would encourage investors to review the names below to see if they are a fit for their portfolios.

JMP Group (JMP)

Why I like it. As I noted in my recent article, Top 12 Ideas for Your Portfolio in 2014, I am a fan of small-cap financials in 2014. We have seen a rebound in the IPO Market, and these rebounds typically last 2-3 years. What's different about this recent rebound is that small-cap investment banks are taking a bigger piece of the pie, most likely due to a greater amount of smaller-sized IPOs. In addition to this trend, JMP also benefits from greater demand for small-cap research. If we look back at the equity business over the last couple of years, it has significantly underperformed. This has created a larger pool of equity investors that have fewer assets under management and fewer in-house resources. This creates the opportunity for a research firm focused on small caps to take market share and a larger pool of managers, now that the equity business has returned and inflows are positive, that are more incentivized to obtain outside research. JMP is in the middle of almost doubling the coverage universe for its equity research product.

Additionally, the company's asset management business is benefiting from higher management fees as a result of equity inflows and 2013 performance, and is reaching an inflection point in size where large, institutional assets will become interested in the product. Even with these positive trends, the stock trades at a discount to its peers:

Price/Earnings

Price/Book

JMP

10x

1.2x

EVR

19.5x

4.1x

COWN

10.5x

0.9x

LAZ

17x

8.6x

SF

16.5x

1.5x

RJF

14x

1.9x

PJC

15x

0.8x

GHL

24.5x

6.4x

OPY

10x

0.6x

Average

15x

2.9x

When looking at these comparable valuations, taking into consideration the fact that the company is growing revenues faster than most of its peers, I see no reason why the stock should not trade in line with the average multiple for the industry. Using a blended valuation of 15x EPS and 2x book value (I am removing some of the high, outlier multiples to be conservative) I get a price target of $11, representing over 50% upside to the current stock price.

Why I think it's safe. At a recent conference, management noted that they have recently been buying back their shares, which they consider "very cheap." Management noted that instead of complaining about how their stock is cheap, they are using it to their advantage and buying it back, and will continue to do so as long as it stays cheap. I believe this fact provides investors with a floor on the stock because if investors are selling near these levels, the company will be buying. The company has stated that the stock, considering JMP has the highest top-line growth of any of its peers, should trade in line with the average 15x EPS multiple for the group and have a price target above $10, so we get a sense of the prices at which the company will buy back stock in the future. Additionally, insiders have been purchasing the stock for their personal accounts, including a recent purchase of over $1MM by CEO Joseph Jolson:

Source

I take this as confirmation that management thinks their stock is cheap. Instead of complaining about it, they are taking advantage of it, and I think investors get a "margin of safety" in the process.

Scholastic Corporation (SCHL)

Why I like it. The company is now reaching an inflection point in its business. The United Sates is moving to a Common Core curriculum, which will cause increased purchases of the company's educational content. Lucky for the education industry (and SCHL), state budgets have started to rebound, and we have even seen some states increase their budgets specifically for this new curriculum. On top of this, more of this money will be spent on technology oriented products, which drive higher margins. Additionally, the company has found ways to make its book fair business more efficient, which will also drive margin expansion.

Considering the Steady state of this company, I believe the valuation on the stock should be fairly straight forward:

  • 0.6x run-rate revenue = $1.2B enterprise value
  • 6.0x run-rate EBITDA = $1.2B enterprise value
  • 10.0x run-rate free cash flow = $1.2B enterprise value

We would conclude that over the long-run, the company should be worth about $1.2B, or $36 per share. We understand that the company has underperformed over the last several years (The recent recession caused school budgets to be cut across the country, which depressed the company's earnings. On top on this, the company has seen a run-off in revenues from its Harry Potter and The Hunger Games content), but the catalysts are finally in place to see the stock return to its normalized valuation.

Why I think it's safe. If we look at the long-term chart (I believe this makes sense because of the steady nature of the business) you can see a range of about $25-40 over the last 10 years:

Source

Additionally, I believe the downside is basically the trailing 12 months of performance on the stock considering it was the worst period the company has had over the past 10 years. Assuming this continues, and using our run rate valuations, we get a downside price target of $25. Overall, this leads me to believe that $25 is the downside on the stock.

John B. Sanfilippo & Son (JBSS)

Why I like it. The company has been going through a transformation of its business as the company moves from being more of a wholesaler to more of a consumer packaged goods company. After reviewing the company's recent results, it seems like the transformation is working. The company has the potential to reach both volumes and margins that the company has never seen before, yet the stock trades at a deep discount to its competition. I believe this is due to a lack of visibility on the story, as the company has no sell-side coverage, has limited trading volumes, and is a small company that isn't very flashy.

When comparing the valuation of JBSS to Diamond Foods (DMND), the difference is quite remarkable:

JBSS

DMND

Price/Earnings

8x

29x

Price/Sales

0.4x

1.2x

EV/EBITDA

5x

22x

EBITDA Margins

7.6%

5.5%

Price/Book Value

1.2x

3.4x

Considering the poor performance at DMND, combined with the positive results at JBSS, I see no reason why there should be such a discrepancy in valuation. Because of the high level of depreciation in the business (over $1 per share), combined with the fact the company will be paying down debt, I believe that EV/EBITDA is the correct metric to use. I am using a valuation based on 6x 2015 EBITDA, giving me a price target of $33, or 35% upside. As the company continues to perform, the stock will become too cheap to overlook.

Why I think it's safe. As I noted above, book value on the stock helps provide a floor on the downside. The company currently trades at 1.2x book value and has some very attractive assets.

JBSS is a pretty steady business, so I don't think investors would need to worry about this portion, but let's just be conservative and assume that the company is never able to sell another nut. The company has a significant amount of company-owned real estate (I have provided an estimation of the value for each property using regional comps):

Sq Feet

Value

Old Elgin*

$6.2MM

Elgin Office

400K

$32MM

Elgin Warehouse

1MM

$60MM

Bainbridge, GA

245K

$6MM

Garysburg, NC

160K

$5MM

Gustine, CA

215K

$6MM

Total

2.02M

$115.2MM

*Old Elgin currently has a carrying value of $6.2MM and has been put up for sale. The company expects to receive proceeds higher than the carrying value.

Though some of this value would be offset by the $67MM of debt on the balance sheet, it does not include the company's machinery, which had an original book value of $166MM.

As I said above, I don't see a situation where JBSS would need to liquidate, but it's always nice to have hard assets behind your investment. Furthermore, considering the stock only trades at 1.2x book value, I see minimal downside in the share price.

1-800-Flowers.com (FLWS)

Why I like it. Beginning in 2014, several of the company's initiatives to cross-brand their various gift businesses will begin to kick in, and as they do, 1-800-flowers will become the go-to place for online gift giving. Yet, when looking at the company's valuation, this inflection point seems to be overlooked, as it trades at almost a 50% discount to its competition. Additionally, as more of the company's business comes from their growing gift segment, which is very much like a consumer packaged goods business, the company will have to be revalued higher (I believe higher than its competitor's valuation). I have a $9, 12-month price target on the stock, but believe that there is more upside in the long-run.

Why I think it's safe. Even if the e-commerce strategy does not work and the company decides to never grow again and instead returns cash to shareholders, investors would still get +10% annual free cash flow returns based on the company's current valuation.

Einstein Noah Restaurant Group (BAGL)

Why I like it. The company is in the process of growing its franchise and licensing businesses at a rate much faster than its traditional, company-owned stores as the company pushes to become more of a "capital light" business model that earns a greater portion of its profits from royalty streams. BAGL only needs a fraction of the multiple expansion achieved by other restaurants pushing the franchise model in order to see a return of almost 100% over the next 2-3 years. And as a bonus, the company will pay you a 3.5% dividend yield while you wait for this transformation to play out.

Why I think it's safe. The sum of the parts on this business is worth substantially more than its current valuation. If the company were to pursue an aggressive refranchising campaign on the store base, assuming current market multiples, we could see a company worth $23 per share. The risk that Greenlight Capital would sell shares has already been priced into the stock with the recent selloff due to the Greenlight sale, which I believe has created a good entry point on the stock.

Bassett Furniture (BSET)

Why I like it. I am a fan of the furniture companies in 2014. I believe there will be a strong home buying season in the spring, which means there will be higher demand for furniture (new homes sales is the biggest driver of furniture sales. I think BSET is one of the best ways to play this trend. The company trades on the low-end of valuation for the furniture brands, yet has ample growth opportunity through margin expansion.

Why I think it's safe. With a book value of $14.50, I see very little downside on the stock. As confirmation of this, we have seen insiders step in and purchase at these levels:


(Click to enlarge)

Source

Conclusion

For those of you focused on small-cap stock, I would suggest that you check out the names I mentioned above. All of these names have company-specific catalysts that could boost the stock, and each of them are fairly steady businesses that, for the reasons I described above, have very little relative downside.

Source: Steady, Safer Small-Cap Ideas For 2014