2014 Small And Mid Cap High Conviction Buys

by: Long-Short Value

As this is my first year as a contributor at Seeking Alpha, I do not have a track record to highlight my past performance in year-end investment picks. In lieu of a track record, I will provide a summary of my investment strategy, so you can make a better informed decision in regards to my investment picks for 2014. My investment strategy from a high level can be categorized as a Long-Short Value investment strategy. My primary investment objective is to achieve capital appreciation by buying securities with trading or market values materially lower than their intrinsic values and by selling short securities with trading values or market values materially higher than their intrinsic values. This investment philosophy has been detailed many times by many great investors from Seth Klarman of Baupost Group in his book Margin of Safety to James Montier in his book Value Investing: Tools and Techniques for the Intelligent Investment.

Every investment has both a market price or market value (the price that you can buy or sell an asset for either on the open market or in a private market) and the intrinsic value (the actual calculable value of a business based on some form of mathematical logic, usually done through a combination of Discounted Cash Flow Analysis, Sum of Parts Analysis, and sometimes Comparable Analysis (Peer Analysis) [Comparable analysis when viewed in a vacuum can be wildly misleading as it was in the 2000 internet bubble]. Comparing Intrinsic Value to Market Value utilizing a ratio of Market Value/Intrinsic Value is a useful tool to describe and understand valuation. To determine if an investment is worthwhile as a value investor, both on the long side and the short side, I use this ratio as a guide. My investment goal from the Long side is to make investments that have Market/Intrinsic ratio between 0.25 - 0.75, and my investment goal from the short side is sell investments short with a Market/Intrinsic ratio of 2 and above. I believe that markets are efficient at clearing as well as pricing supply and demand of securities, but those directing the supply and demand of markets are not efficient at correctly valuing those securities for multiple reasons.

With that said here is my list for 2014 small and mid capitalization (below $10 billion) stocks that I believe have a high likelihood to outperform in 2014. I will follow up this list with a list of companies that I believe have a high likelihood to underperform in 2014 within the next week.

Atwood Oceanics

Atwood Oceanics (NYSE:ATW) is a medium sized high specification offshore driller similar to Transocean (NYSE:RIG) or Seadrill (NYSE:SDRL), but smaller in market capitalization and fleet size. The main reason I think it will have a strong 2014 is that the addition of 2 new Ultra Deepwater Drillships in the next 6 months will significantly change the revenue trajectory and set the company on a course to become free cash flow positive in 2015. See my recent article with my thoughts.

Market Price 12/31/13: $53.39

Intrinsic Value (based on DCF) : $71.45

Market Price/Intrinsic Value Ratio: 0.74

Nuance Communications

Nuance Communications (NASDAQ:NUAN) is a voice and language solutions services company including their consumer software under the name "Dragon" which some of you may be familiar. The stock of Nuance has taken a beating from the market in the back half of 2013 for concerns over revenue disappointments/decline and high executive pay. Carl Icahn has taken a significant stake in the company holding 52M shares out of 311M outstanding shares or 16% of the company. The company is currently undergoing a revenue model transition from a license model to a higher margin and less volatile subscription model. This revenue model transition will cause revenues to be artificially low in the short term but be a positive for revenue stability and margins over the long term. The technology has a strong moat in the voice and language solutions space, and the current market concerns will disappear in 2014, which makes it a strong investment at a low forward P/E of 12.53.

Market Price 12/31/13: $15.20

Intrinsic Value (based on DCF) : $24.14

Market Price/Intrinsic Value Ratio: 0.62

Rosetta Resources

Rosetta Resources (NASDAQ:ROSE) is an Oil & Gas Exploration and Production company with great assets in the Permian and Eagle Ford Shale basins. Rosetta operations have been confined to the Eagle Ford Shale region until the 2013 purchase of Permian Basin assets from Comstock Resources. Both the Permian and the Eagle Ford shale regions are in Texas and produce highly advantaged crudes that are priced in WTI versus its Bakken counterparts. This price differential has recently jumped due to transportation and infrastructure issues getting Bakken crude to the Gulf Coast Refineries.

Debt levels are currently high at Rosetta at 89% Debt/Equity ratio, but the cash flow growth generated from the two major drilling programs will begin to turn the negative free cash flow balance towards a positive. Rosetta is a well run company with strong assets in price advantaged regions in Texas well positioned to build oil production, trading at a reasonable market price.

Market Price 12/31/13: $ 48.04

Intrinsic Value (based on Sum of Parts Analysis) : $64.5

Market Price/Intrinsic Value Ratio: 0.75

Science Applications International Corp

Science Applications International Corp. (NYSE:SAIC) is an engineering and IT contractor for the US government that was recently a part of a spin-off from its parent company by the same name . The spin-off was largely one of necessity due to the Federal Acquisition Regulation (restricts contract awards when it is perceived that contractors have a competitive advantage or economic incentive as a result of holding multiple contracts for government entities). The spin-off left SAIC with the engineering services and IT businesses, while Leidos (NYSE:LDOS) [renamed parent company] was left with the National Security, Health, and Engineering businesses. This spin-off was largely under the radar as both sides of the spin-off's businesses have suffered revenue declines in 2013 as the government has cut funding. SAIC's core business is to provide IT infrastructure and support to DoD for large technology projects. SAIC is a strong investment in 2014 as the DoD will continue to shift spending to IT infrastructure and IT related support as they combat global cyber security.

Market Price 12/31/13: $ 33.07

Intrinsic Value (based on DCF) : $50.30 (Assumes -5% revenue growth in 2014)

Market Price/Intrinsic Value Ratio: 0.657

AeroVironment, Inc.

AeroVironment, Inc. (NASDAQ:AVAV) is a small cap manufacturer of small unmanned aircraft, electronic vehicle (EV) charging stations, and other technology solutions. AeroVironment has a stellar combination of high growth products in small unmanned aircraft and EV charging stations. Both of these products alone would warrant a look at the company. The company recently reported a massive jump in its backlog from $59M in April to $133M in October. This all comes on a back of the recent hearing at the US congress to review Unmanned UAVs laws and development in the US. I believe AeroVironment is in a great position for growth as well as it will likely be a takeover target for large defense contractors like Lockheed Martin or Aerospace companies like Boeing or even technology companies like Google (Google buys Boston Dynamics). I think AeroVironment is actually fairly valued at the current price, but I think a buyout or P/E expansion is likely in 2014.

Summary Table:

Ticker Market Cap $M P/E Forward P/E PEG P/B EPS growth next 5 yrs Dividend Yield Return on Equity LT Debt/Equity
ATW 3352.62 9.85 6.51 0.42 1.52 23.50% 16.60% 0.57
AVAV 634.81 50.62 2.04 14.00% -0.80% 0
NUAN 4775.4 12.66 1.81 3.00% -4.30% 0.8
ROSE 2852.74 12.44 12.94 0.54 2.17 23.10% 20.00% 0.89
SAIC 1651.79 13.48 11.99 2.25 4.93 6.00% 3.32% 22.30% 1.48

Source: Finviz

Notable Mentions for 2014: KKR, Lindsay Corp. (NYSE:LNN), and Community Health Systems (NYSE:CYH)

Disclosure: I am long ATW, ROSE, NUAN. 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.

Additional disclosure: I have no positions in AVAV and SAIC, but may initiate a long position over the next 72 hours.