Conference Souvenirs: 5 Interesting Small Cap Ideas

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Includes: CLIR, PCTI, SHLO, TLRA, UFPT
by: Erik Kobayashi-Solomon

Wednesday, I spent the day at the Midwest IDEAS Conference sponsored by Three Part Advisors, and held at the Gwen Hotel in the City of Big Shoulders, Chicago, Illinois.

Three Part holds three conferences dedicated to uncovering the best small capitalization stock ideas each year; one is held in Dallas, one in Boston, and one is the Chicago conference I have been attending for several years. The conferences are great places for accredited investors (i.e., investors meeting some minimum wealth and income hurdles or institutions that act on behalf of wealthy investors) to sit down to speak with small cap companies' management teams and to pick the brains of other savvy investors.

While so-called "passive" investing - dumping assets into index-tracking ETFs or funds - has become popular during what some say is the longest bull market in American history, there are good structural and behavioral reasons for paying attention to small capitalization companies.

Structurally, the Investing-Industrial Complex - the big sell-side banks like Goldman and Morgan - usually dedicate little to no research resources to these firms because the investment banking fees and trading commissions from these small cap firms are so small. On the buy-side, if a $20 billion fund bought a $100 million market company outright, it would only represent a 0.5% position in their portfolio; even if that position doubled or tripled in value over the next year or two, it would hardly move the fund's performance needle.

Behaviorally, even the investors who still like to pick stocks can be put off by smaller companies simply due to the difficulty in forecasting business outcomes. If a start-up business owned by a mega-cap company has a tough quarter, an investor in the mega-cap would never know about it, especially if the other mega-cap business lines were firing on all cylinders. However, if that same business were its own separate entity, the quarter's difficulties would be on full display because there are simply no other businesses to take up the slack.

The combination of disinterested large institutions and gun-shy individuals often means an intelligent investor can find some real bargains among small capitalization companies. The secret of exploiting these bargains is understanding what makes them tick and using that understanding to figure out what they are worth. After sitting through a dozen talks yesterday, I came back with five companies into which I want to dive deeper and start the process of assessing the firms' value drivers.

ClearSign (NASDAQ:CLIR) : Manufacturer of technology to lower NOx (Nitrous Oxide) emissions from natural gas-fired utilities and from petroleum refineries. Long sales cycle with large buyers who must verify the technical specifications of any new products before buying them has meant that revenues have been slow in ramping up. The company says that orders are improving and that this will soon lead to much healthier revenue growth.

Figure 1.

PCTEL, Inc. (NASDAQ:PCTI): Manufacturer of WiFi, 4G, and 5G antennas and of testing equipment for wireless networks. Several large clients just pushed back orders and the company brought down revenue forecasts considerably; as such, the stock price fell heavily. However, the company looks to be generating adequate cash flows to cover its 5% dividend yield and management claims the revenue shortfall is temporary rather than structural.

Figure 2.

UFP Technologies (NASDAQ:UFPT): Manufacturer of specialty packaging and other disposable materials for medical (60% of revenues) and other industries. The fact that the company's client list is diverse, that its products enjoy more or less constant replenishment demand, and that the parts it makes are relatively inexpensive compared to the end products suggests that the demand environment would be stable even in a downturn. Revenue growth - boosted by acquisitions - seems robust, but Owners' Cash Profit margins have shown a decreasing trend over the past 10 years. This seemed like a particularly interesting business to own, so I'll probably start my valuation analysis on this one.

Figure 3.

Telaria (NYSE:TLRA): Telaria has built a software platform that helps video content providers integrate and track advertisements into their programs. This company is in the midst of transition, so its historical financials are of limited use in understanding the firm. Telaria is targeting the quickly growing market of providing an advertising platform for "Connected TVs" (CTVs) and the company's management claims Telaria is one of the three leading firms in this infant industry. The significant operational leverage in this business is especially attractive to me.

Figure 4.

Shiloh (NASDAQ:SHLO): Manufacturer of light-weight components to automobiles' body, chassis, and propulsion systems. Pulling weight out of vehicles makes internal combustion cars more fuel-efficient and increases the range of electric and hybrid vehicles. Considering all the news stories about tariffs and trade frictions, this might seem like a strange pick, but the CEO seems very capable and smart and his pitch piqued my interest. Note that the company took on debt to make several recent European acquisitions, but management is targeting a debt-to-equity value in the 2.5x range.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.