6 Small Companies With Big Cash Stashes And High Insider Ownership

by: Alan Brochstein, CFA

One of the more interesting stock stories last week was the 33% surge in Liquidity Services (NASDAQ:LQDT). The company, which provides reverse supply chain services (in plain English, they help stores get rid of returned merchandise as well as assist governments in dumping excess goods), has many attributes that were helping the stock perform well prior to their big announcement on Thursday that they were making a highly accretive acquisition.

LQDT has reported sales growth of 19% and more than doubled its earnings over the past year. Prior to the big move, it was sporting a PE of about 24X, but it also had substantial cash net of debt (approximately 16% of the market cap). Given that the cash earns almost nothing, the adjusted PE was about 20X forward earnings - not bad for a fast grower that has a business model well in tune with the times. Another factor of note is the high insider ownership at 38% at the time of the last proxy.

LQDT surged because they apparently have deployed their excess capital brilliantly. As a result of the purchase of a rival, they expect earnings in FY12 to be 33% higher than analysts had been expecting (.30-.35 accretion, 1.02 EPS prior consensus). The entire purchase, which was financed mainly by cash and debt, was $140mm (with a $30mm potential earnout), was about 21% of the entire market cap of the company before the announcement.

One of my themes since the 2008-2009 crash has been to find smaller companies with substantial cash balances. My thinking has been that these companies might make good acquisition targets, but this LQDT transaction suggests the potential for high returns through smart capital deployment as well. My Top 20 Model Portfolio has over 1/2 its holdings in Small-Caps (which has been painful these past few months!), almost all of which have loads of cash. One company we purchased in 2010 was added because they pulled off a brilliant acquisition that the market didn't initially notice. Insteel Industries (NASDAQ:IIIN) ended up running more than 50% afterwards, but it has now done a complete round-trip despite what appears to be a successful integration of their former competitor. Insiders owned about 9%. We also had luck with Copart (NASDAQ:CPRT), which tendered for a large amount of its stock earlier this year. Insiders there owned about 19%.

Small companies with large cash balances relative to their market cap and high inside ownership may offer opportunities for patient investors. While any company can theoretically spend cash or borrow to make an accretive deal (with interest rates at zero), the alignment of directors and officers with high stakes prevents companies from goosing their near-term earnings with long-term value destroyers.

While it's impossible to make a buy decision on just these two parameters (net cash divided by market cap, insider ownership), it's a great start. My screening tool doesn't have either of these metrics precisely, so the following took some manual adjustments. As LQDT proved, it doesn't have to be 50% of the market cap in cash, and "enough" insider ownership is probably sufficient. I believe it's possible that there can be too much insider ownership. So, these examples, which aren't complete, were chosen because net cash to market cap was in excess of 20% and insider ownership was between 10% and 50%. I also restricted 5-year average return on capital >10%. Here are some I found. Click to enlarge:

What I like about this prospecting list is that 6 different economic sectors are represented. I have also included some valuation and growth metrics. All six of these companies have been growing strongly. Whether there is hidden value in the underappreciated cash or whether the cash can be used strategically for M&A or share repurchases, these six companies have very large insider ownership which should hopefully align the Board of Directors with shareholders.

Disclosure: I am long IIIN. IIIN is included in the Top 20 Model Portfolio at Invest By Model