By David Sterman
In recent weeks, I've been focusing all my efforts on large- and mid-cap stocks, especially those with strong balance sheets and consistent free cash flow. Many of these rock-solid companies offer a degree of stability in this choppy market and are currently trading at outstandingly cheap values. In effect, they allow you to play offense while being defensive.
On the flip side, small- and micro-cap stocks are far less resilient. As investors continue their "flight to quality," these stocks are being deeply shunned. Until we have a clear sense of the potential duration and depth of a possible looming recession, investors will keep selling off smaller company stocks.
But there's a curious twist to this oft-repeated cycle. When the recession finally arrives (which is still not a given), small stocks tend to actually outperform. We're now cycling through the 20-year anniversary of just such a move, and you need to watch for signs of another breakout.
Back in 1990, the U.S. economy was quickly losing steam when gross domestic product (GDP) growth fell from a robust 4.2% in the first quarter to -3.5% in the fourth quarter. This should have spooked small-cap investors. Instead, they started to buying aggressively, anticipating the eventual economic rebound.
The Russell 2000 Index of small-cap stocks bottomed out at the end of the third quarter of 1990 at 119, but it would hit 144 by year-end (even though the economy slumped badly that quarter), and would hit 178 by the following May. That's a 50% gain in just seven months, even though the economic data painted a bleak picture. (The index went up to about 200 by the end of 1991, even though GDP growth didn't prove to be robust until the first quarter of 1992.)
The key takeaway: small caps represent great buying opportunities, even when the economy looks scary, so it pays to keep a watch list prepared. Here are three small-cap stocks that could double or even triple in value when the Russell 2000 finally rebounds. It may take a few years for this to fully play out, but the upward move may come sooner than you think.
1. Power One (PWER)
This is a solid company stuck in a tough industry. Power One makes a range of power conversion and power-management components. The company has had notable recent success with inverters that help solar panels and wind turbines convert their variable power generation into energy flow that is suitable to feed into electricity grids. This has proved to be a choppy business, because the renewable fuels industry has seen major peaks and valleys. Still, Power One is taking market share from rivals, maintaining sales levels while rivals see sharp drops.
Power One is likely to post flat sales this year of $1 billion. Earnings per share (EPS) are expected to fall about 20% to around $0.90 this year. Growth is likely to resume in 2012 at a moderate double-digit pace as stalled power projects finally come to fruition. Meanwhile, shares trade for just five times trailing earnings. As business moves back up onto a growth trajectory, look for the multiple to move up into the low teens, implying at least a double for this beaten-down name.
2. Exide Technologies (XIDE)
In keeping with the energy/power theme, this auto battery maker has been too sharply discounted. (I recently suggested Exide could be part of a paired trade strategy.) The company had seen profits slump as lead prices surged. Lead is Exide's biggest raw material expense.
The company belatedly pushed through price increases for its batteries, which should help profits rebound. As a further tailwind, lead prices are finally in retreat. They peaked above $1.30 a pound in the spring, and are now $1.05. As those factors finally hit the income statement, look for much better quarterly results. In a stable pricing environment, Exide's annual operating income could hit $200 million, which is more than half of the stock's current market value. Simply applying a multiple of five on normalized operating income would make this stock triple.
3. KIT Digital (OTC:KITD)
This is a very promising -- and hugely frustrating -- company. KIT has built an impressive suite of products to help companies develop sophisticated video services on a wide range of platforms. Thanks to an acquisition spree, the company now has a broad set of tools to offer, which is fueling 100% sales growth this year and projected 40% sales growth (to $300 million) in 2012. To pay for these deals, the company has raised fresh capital several times. The number of shares outstanding keeps rising -- from 7 million in 2009 to a recent 33 million -- and shares take a big hit every time another capital raise is announced.
Management is expected to finally stop issuing fresh equity, which should enable investors to focus on the attractive core business. Recent major contract wins with John Malone's Liberty Global and Korea's LG should help KIT to post very solid growth metrics in coming quarters. This sub-$10 stock could move north of $20 when quarterly results are more robust and investors finally can trust that no more capital raises will be needed. A $20 target price implies a target 2012 EBITDA multiple of just 10, which is quite reasonable for a high-growth stock like this.
Risks to Consider: Small caps like these will only find traction with investors once they prove their ability to boost profits, regardless of expectations about the broader economy.
My friend Andy Obermueller, editor of Game-Changing Stocks, often says investors should allocate about 20% of their portfolio to more speculative high-growth stocks. While not the game-changers Andy typically looks for, these three stocks certainly fit the high-growth bill. All of them were in the teens earlier this year, but I expect them to return to previous peaks once the near-term gloom abates. Although they appear to have solid upside during the next 12 months, each also looks well-poised for continued strong growth in their respective industries, which could help them rise even higher beyond 2012 as well.