4 Small Cap Stock Ideas for Uncertain Economic Times

by: Bradley Safalow

At PAA Research, we are firm believers in Edward Leamer's thesis that "housing is the business cycle". The findings from our most recent report, "A View from the Frontlines of Housing" backed by a survey of approximately 1,000 residential real estate brokers indicates that the housing market is unlikely to recover any time soon. The expiration of the housing tax credit and other fiscal stimulus measures are likely to result in a much slower growth trajectory for the US economy over the next 12-months, perhaps longer. Additionally, the ongoing threat of sovereign debt defaults in Europe, the prospects for slower growth in China, the absence of job growth, and spiraling municipal budget deficits imply that economic growth in the US and for the rest of the world could be below trend for the next several years.

In an environment of lackluster economic growth and capital markets uncertainty we think it is most prudent to focus on individual stocks rather than sectors or even markets. The time for "beta" plays has passed and we think those who can consistently generate "alpha" over the next several years will deliver strong returns. At PAA Research during this period of economic uncertainty we continue to focus on companies that will benefit from secular growth, operate in acyclical end-markets, or are in the midst of a turnaround. To be clear, we're not recommending to pile into consumer staples, healthcare, and Treasuries and to turn off the lights. We still think there will be plenty of companies that deliver strong revenue, earnings, and free cash flow growth over the next several years. We're avoiding names with significant exposure to Europe, China, and the housing market.

Below we discuss our investment thesis on four companies that meet our criteria:

  • Imperial Sugar Company (NASDAQ:IPSU). The vilification of high fructose corn syrup has created a surge in demand for refined sugar products. Through April of this year, overall sugar usage in the US increased 9% and that by beverage companies alone increased 25%+. Sugar demand is largely driven by population growth and consumer preferences, not the broader economy. As the largest independent sugar refiner in the US, IPSU is well positioned to benefit from higher sugar prices. Historically the spread between raw sugar and refined sugar prices has expanded during periods of higher prices. Based on our checks with sources in the sugar industry, pricing should be favorable for IPSU over the next 12-months. IPSU shares trade at 0.5x book value and 6x our normalized earnings estimate due to investor concerns about productivity at the company's largest refinery in Port Wentworth. Our recent conversations with management indicate the company has resolved many of the production issues at the plant. It appears that IPSU is on the cusp of unleashing its true earnings power. Our sum of the parts analysis indicates that IPSU shares could be worth as much as $25-$30 in a sale scenario.
  • THQ, Inc. (THQI) - THQI is a leading independent developer and publisher of video games. The interactive entertainment sector has not been a money-maker for longs over the past 12-months. We anticipate new product innovations from Microsoft, Sony, and Nintendo should help improve sentiment in the sector. However, our enthusiasm for THQI shares is largely based on the company's turnaround efforts and compelling video game release slate. THQI shares now trade at 1.0x tangible book due to relatively disappointing initial sales of UFC Undisputed 2010 and the company's decision to subsequently lower guidance for all of 2010. It looks like 2010 will be a break-even year for THQI. However, 2011 is shaping up to be spectacular. The company's upcoming video game release slate over the next 12-18 months is highlighted by a compelling combination of owned IP and licensed games. Our title by title buildup for calendar 2011 indicates that THQI can generate $1.2-$1.3 billion in revenues and $1.00+ in EPS.There are few catalysts for shares in the next 3-6 months, but we think the stock could trade well north of $10 once investors gain confidence in the company's upcoming title slate.
  • Acuity Brands, Inc. (NYSE:AYI) - For those who are familiar with the company, you might be wondering how it got on this list of supposedly acyclical, secular growth, and execution stories. As a leading manufacturer of lighting equipment, AYI does service highly cyclical end-markets. However, the lighting industry is in the midst of a seismic shift towards LED products and lighting control solutions. Despite the ongoing downturn in housing and non-residential construction, our checks with lighting distributors and lighting designers indicate demand for LED and lighting control products continues to increase double-digits YOY. Additionally, the mandated phase out of the indandescent light bulbs starting in 2012 should start to boost demand for AYI's energy efficient products as soon as the second half of this year. The company generates sizeable free cash flow (FCF to net income of 130%+) and has ample dry powder to pursue "tuck-in" acquisitions as well. We anticipate the stock is poised for further multiple expansion and earnings outperformance as investors growth more enthusiastic about LED demand and the implications of the phase out of the incandescent bulb.
  • The Knot, Inc. (KNOT) - The Knot is a leading "life events" media and ecommerce company. Through its core brands - the Knot, WeddingChannel, the Nest, and the Bump, the company provides services to young couples, advertisers, and retailers targeting the wedding, young couple, and pregnancy markets. Every year 2.2 million adults get married and 4.6 million women have a baby, of which 1.7 million are first borns. The economy has no bearing on the number of weddings or birth-rate in this country. The KNOT is a $100 million top-line company servicing industries whose aggregate spend exceeds $110 billion. The company's flagship brands are well known and respected. The stock has underperformed this year due to the modification of the company's relationship with Macy's. We think this represents an over-reaction. We estimate the new Macy's relationship will reduce revenues by $2 million in both 2010 and 2011. However we think a number of the company's growth initiatives could more than offset the decline in revenues from Macy's including: improved local advertiser yields, a recovery in national advertising spend, expansion of the number of publications annually, enhanced ecommerce offerings, and growth in the number of registry partners. With a market cap of $240 million, no debt, and $132 million in cash, KNOT has a lot of options to unlock shareholder value. The company announced a $50 million share repurchase authorization in February, we expect the company to start to buyback stock this quarter. We think the stock can trade north of $10 with improved execution and if the company starts to repurchase shares.

You can read more about each of these companies at our website.

Four names, four investment ideas that should deliver outside returns in a weak economic environment.

As always, please act accordingly....

Disclosure: Author holds long positions in IPSU and THQI