Best Of The Worst: 6 Beaten-Down Small-Caps Worth A Look

by: Alan Brochstein, CFA

A rising tide apparently doesn't lift all boats, as 58 stocks in the Russell 2000 (NYSEARCA:IWM) are down more than 20% so far in 2012, despite the >10% rise in the index. While I don't suggest looking for all one's new buys from the list of laggards, I looked at the biggest losers in the Russell 1000 last month, and several of them have popped nicely. One notable stock is Carbo Ceramics (NYSE:CRR), which was the most interesting one and generated a lot of comments. With smaller companies, the likelihood of negative reactions proving to be overreactions is high given limited liquidity. Bad news, even if it is just transitory, can crush small stocks.

Small-Caps got off to a great start this year but have lagged over the past month, though they enjoyed this past week, regaining the lead vs. the S&P 500. As I have shared, I expect Small-Caps to be big winners in 2012, so I wanted to look at some of these early losers for possible new ideas. While I am sure that there are likely several potential bargains among the 58 20% decliners, I narrowed the list by restricting the market cap to $500mm and by requiring expected EPS growth to be positive in 2012 and to be > 10% in 2013. Here are the 6 stocks that made the cut, sorted by YTD losses:

Click to enlarge

Small-Caps Down Big

Please keep in mind that these aren't recommendations. I am familiar with most of these companies, but I follow only one closely and had never even heard of another, until it showed up here.

Balchem (NASDAQ:BCPC) is a specialty chemical company that I have followed because one of my clients has owned it for years. It's the kind of stock that one rarely gets a good opportunity to buy, and I think this is one. The far column is the StockVal Price Momentum Indicator, which is a mathematical calculation based on moving averages. Typically, an extreme score is 2 units, so BCPC, at 3.7 units oversold, is an off-the-chart reading. The stock isn't very volatile, so the sharp move counted for a lot.

After several quarters where everything seemed to go right, this quarter saw several major issues. The one that really surprised me was that the company's sales of choline into the fracking market have been hurt by the transition from gas to oil, as apparently its additive isn't needed for oil fracking. Its business tends to be lumpy, and it took some lumps in the company's animal health business too. The stock typically trades 20-25 PE, and it is at the low-end off of reduced numbers, and this doesn't include the $3.50 roughly in cash net of debt. I like that the company typically generates FCF in excess of 100% of NI. If you are looking for a high quality name, this one is probably worth spending some time on.

Heckmann (HEK) is one of Jim Cramer's favorites. The company, which was a blank check company formed in 2007, is focused on water and wastewater solutions for shale oil and gas exploration and production. One of its big projects was in the Haynesville (underground pipelines) and it also operates 600 trucks and 1100 frac tanks. Besides the Haynesville, it operates in the Eagle Ford, the Marcellus, the Barnett and Tuscaloosa Marine (in Lousiana). Chesapeake (NYSE:CHK) was a 25% customer last year, and El Paso (EP) and Exco (NYSE:XCO) were 16% and 12% respectively. The company expects to reduce CapEx from $150mm last year to $70mm in 2012. CEO Richard Heckmann retired from K2 (sporting goods equipment maker) after turning it around from 2002-2007. Previously, he founded USFilter in 1990 and sold it to Vivendi for $8.2 billion in 1999. While there, he did 150 acquisitions.

Digital Globe (NYSE:DGI) is in my Top 20 Model Portfolio, which is doing quite well this year despite the drubbing on this one! We got involved with this one in the mid-20s last May, focused on a new CEO we like and optimistic about the long-run potential for the company's high-resolution satellite imagery. Given how much of its revenue comes from the government, the past seven months have been quite challenging for the company, as investors have priced in potential reductions in their expected contractual revenue.

The most recent quarter showed some exciting growth, but guidance for 2012 disappointed investors. Of course, the $64K question regarding what will happen with the government contract remains open. Part of the future growth comes from up-selling the government, and this will likely prove a challenge in the near-term. There is no near-term liquidity issue, but the company does have debt, so any radically negative changes in future sales and earnings are a risk. Still, the stock trades at a very low multiple of trailing EBITDA (EV/EBITDA = 6X), and at 1.2X tangible book value. If this works, the upside could be quite significant. It has a rival, GeoEye (NASDAQ:GEOY), which is under heavy accumulation by Cerberus, but I think that DGI is the better bet.

True Religion (NASDAQ:TRLG) is the kind of place that I would never shop, as I can find 3 or 4 pairs of jeans for the price I would pay for a single pair there! Thankfully for this company, there are plenty of people willing to fork over $100 or more for high-end jeans. The stock had been in a strong uptrend, printing an all-time high recently, before getting slammed on weak guidance. There is no significant demand issue here but rather an expense challenge, as the company is expanding rapidly.

Analysts cut 2012 EPS projections from 2.37 to 1.94 (+ 4%) while modestly trimming sales estimates to 10% growth. The company continues to evolve from a wholesaler to a retailer. Big drivers include continued domestic store openings (11% expansion this year to 121 stores), expanding international sales, and increased e-commerce. With about $8 per share in cash, this stock looks very inexpensive to me. CEO (and founder) Jeff Lubell knows this industry well. He reduced his stake last May at what proved to be not very good timing. This one looks very interesting to me.

CEVA (NASDAQ:CEVA) has been consolidating a big run for the past few quarters and is still up a little over the last year. The company licenses programmable DSP cores and application-specific platforms. The company was slammed at the end of January when it reported an in-line Q4. Guidance for the year was in line with the consensus, but the Q1 guidance was somewhat below expectations. Gross margins are expected to be 94%. The current PE is as low as it has been for the past several years, and, additionally, the company has about $6 of cash and short-term investments.

IPC The Hospitalist Company (NASDAQ:IPCM) is the largest provider of hospitalist services, with 1201 providers at 365 hospitals and 550 inpatient and post-acute care facilities in 25 states. The company was slammed early in the year when it pre-announced negatively. Longer-term, this stock has been in an uptrend, more than doubling since its IPO in early 2008 before its retreat over the last few quarters. The company seems like it lowers costs and improves outcomes. Despite diminished expectations, analysts are forecasting mid-teen growth over the next few years. The 18PE seems reasonable, especially considering the $2 per share in cash on the balance sheet.

Disclosure: Long DGI and CRR in the Top 20 Model Portfolio at Invest By Model