Recent Market Spikes Favor Small-Cap Soup Companies

by: Options Markets

The General Mills (NYSE:GIS) third quarter earnings results were better than the consensus estimates, with the company reporting its net income at $398.4 million (60 cents per share), which was a modest improvement from the $391.5 million (58 cents per share) seen the previous year. Net sales were higher by 7% (coming in at $4.43 billion). Analysts were expecting earnings per share to come in at 58 cents. The company's full-year outlook, however, showed warning signals which suggested that these upside surprises are less likely in the medium term.

This suggests that the recent bounce in stock values might be short-lived and provide a good opportunity to sell short shares in GIS (along with other large cap players in the domestic soup markets). for General Mills, the less optimistic viewpoint is based on the expectation that rising costs (for merchandising, grain, and fuel) will put pressure on margins and bring reduced earnings performance in the coming quarters. Recent trading activity looks to be early precursor of potential declines, as hedge funds and inside players are seen selling the stock at its recent spike highs, in what should later be a reversion back to the long-term mean for GIS (in the mid-30s).

Looking Elsewhere at HNZ, CPB, and MDLZ

Looking elsewhere for stocks to buy in the space, Heinz (HNZ), Campbell's (NYSE:CPB), and Mondelez International (NASDAQ:MDLZ) are some of the most commonly watched alternatives. But when looking at valuations (on a price to earnings basis), a similarly bearish picture emerges. Campbell's has made headlines recently as the company tries to revamp its image (and target younger demographics). On a price to earnings basis, CPB is still trading below 19 but the historical trading ranges present limited opportunities for investors focused on long-term growth. Other common alternatives for the space include Heinz and Mondelez International. Heinz is now seen trading with a P/E above 22 and has encountered a significant spike recently (above the $70 level) and this creates a scenario that is similar to what can be seen in GIS.

Potentially negative factors in Heinz have been seen after the company announced buyout plans (from Berkshire Hathaway and Brazil's 3G Capital, for $28 billion), after which the stock rallied 20% in one day.

For conservative investors, however, this should be viewed as another sell-able bounce, as the Securities and Exchange Commission (SEC) has filed complaints related to suspicious trading activity. Any additional evidence of wrongdoing could deflate the stock from its already elevated levels, in what should be viewed as an overvalued market when looking at the large cap options.

Further indications that the sector is potentially overvalued (and ripe for selling) can be seen with MDLZ, with its P/E ratio above 35. On a long-term basis, MDLZ should be viewed as an even less attractive prospect than GIS and HNZ for these reasons. Below, we can see a 10-year chart showing the recent anomalous activity in HNZ, as the extremes here are quite obvious, and similar trends are starting to appear in valuations for the sector as a whole.

Watching Small Cap Alternatives for Long Positions

Long-term growth prospects in this space are notoriously limited, so for those looking for exposure with solid growth prospects, some small cap alternatives should be considered. This is true now more than ever, given the extreme price activity that we have seen in both GIS and HNZ, and the over-extended P/E valuations in MDLZ.

To get a sense of what long-term growth investors should favorable as a favorable sector choice can be found in small caps, with SoupMan (SOUP.OB) as one clear example. As a relative comparison, SOUP offers a much more solid value for risk-tolerant investors that are focused on growth prospects in a generally limited industry. SoupMan's high-quality product, good brand recognition, and highly visible team of celebrity equity partners utilizes a scalable business model that is free from large Cap-ex necessities.

Headed by former Outback Steakhouse chief Tim Gannon, SOUP is one example of a company with a strong balance sheet that is looking to strengthen its foothold in the $6 billion domestic soup market. The company has clearly set its sights on targeting the markets commanded by the bigger players in the industry (such as GIS, HNZ), and, on a strict value basis, it makes a lot of sense to consider smaller alternatives like SoupMan when looking for long term growth in the sector.

Most significant for potential buys in the sector's small caps is the fact growth value (rarely seen in the space) can still be found, making stocks like SOUP an extremely attractive opportunity when compared to its main line heavyweight competition (GIS, HNZ, and MDLZ). Products with business models that support market valuations well above current market levels can still be found, but it takes some added research to look beyond the industry leaders and find good values. Statements from Campbell's CEO suggest that some of the strategies offered by small-cap players (such as catering to customers in both restaurants and supermarkets) provide significant advantages for potential growth prospects over the longer term. This is something that traditional companies (like General Mills) have attempted to do for years, but little has been shown for these efforts. So, for early-stage investors, small cap alternatives offer some interesting opportunities for long term buy positions, especially when taking the negative scenarios for industry competition (GSI, CPB, HNZ, MDLZ) into consideration. Market signals here: sell GIS and HNZ at their highs, and consider small-cap alternatives not traditionally on the market radar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.