Hidden Gem Exploration: Smaller Caps Earning Top Quality Scores - Part 1

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Includes: CHE, EGOV, EXPO, FAST, FDS, GWW, MED, MSM, PETS, SECI, SEIC
by: Steven Chen
Summary

For individual investors, underrated smaller-size companies could be the best bet to find values.

I run my Quality Scoring model against the whole universe of the S&P Mid-cap 400 and S&P Small-cap 600.

First 4 stocks from the result are discussed in details.

Background

Understanding the "size disadvantage" in the investment world, long-term investors should focus their cherry-picking on small- and mid-cap stocks to beat the Pro. After all, in today's market, where the valuation is hefty and everyone seems to chase the craze, underrated smaller-size companies could be the best bet to find values.

As an initial and quick screening, I would like to run my Quality Scoring model against the whole universe of the S&P Mid-cap 400 and S&P Small-cap 600 in hope to find some candidates underappreciated by mass media but possessing a few of the following characteristics:

  • Consistently superior returns on capital;
  • Low CapEx requirement;
  • Strong cash flow;
  • Decent balance sheet;
  • Healthy growth.

I set the threshold of passing to the score of at least 60, which would give me around 80 stocks if I run the model against the total US market.

From the result, I manually removed those who had any negative annual earnings or negative annual FCF during the past decade, which I would not invest no matter how high the scores are.

Stocks that I previously covered here in the SA community are also excluded, but I should give them the honorable mentions: SEI Investments (SEIC), FactSet Research Systems (FDS), NIC (EGOV), and PetMed Express (PETS).

Now, the final list gives me 8 small- or mid-cap stocks. In this article, let's take a detailed look at 4 of them.

Chemed (CHE)

Headquartered in Cincinnati, Ohio, Chemed Corporation operates two wholly-owned subsidiaries: VITAS Healthcare Corporation, the nation's largest provider of end-of-life hospice care, as well as Roto-Rooter, the nation's leading provider of plumbing, drain cleaning, and water cleanup services.

Despite the boring story here, the management delivers high returns on capital year after year (see below).

Source: Morningstar; data as of 5/14/2019.

The company possesses monopoly-like positions in the market, especially in terms of its Roto-Rooter subsidiary, serving approximately 90% of the U.S. population and approximately 40% of the Canadian population.

For the past decade, Chemed grew its sales modestly (at mid-single-digit rates mostly) but consistently (only one negative annual growth).

Source: Morningstar; data as of 5/14/2019

The free cash flow generation, however, was not as stable from one year to another (see below). But the good thing is that very little CapEx (no more than 4% of sales) is needed to maintain operations for the company.

Source: Morningstar; data as of 5/14/2019.

It is worth noting that the company's owning two totally different businesses is not the optimal structure from a shareholder perspective. Also, the VITAS business does face some concentration risk, with approximately 75% of the consolidated net accounts receivable due from Medicare, Medicaid, and managed Medicaid. Meanwhile, I do believe that VITAS does have a good growth prospect benefiting from the aging population, and both businesses are recession-proof.

The share of CHE does look a bit expensive with over 25x. Compared to the historical averages, the price multiples seem fair on the P/E and P/CF side but not in terms of dividend yield and P/S. In light of the 10-year high cash flow margin and 10-year low tax rate at the moment, as well as my estimate of a high-single-digit EPS growth moving forward, I recommend investors put the stock on their watch list and look for a more favorable entry point.

Source: Morningstar; data as of 5/14/2019.

MSC Industrial (MSM)

MSC Industrial is one of the largest industrial equipment distributors in the world. The company is most famous for publishing "The Big Book", a catalog totaling over 3,000 pages detailing its products, which currently number over 1 million.

Although operating in a highly-fragmented industry, the management has been able to generate consistently decent returns on capital over the past decade (see below), thanks to the scale advantage and Amazon (NASDAQ:AMZN)-proof nature of the business.

Source: Morningstar; data as of 5/14/2019.

The business, however, is not immune to economic downturns. The revenue, for example, dropped by double digits in 2009.

Source: Morningstar; data as of 5/14/2019.

The CapEx requirement is low - less than 4% out of total revenue is spent annually as new capital investment. The FCF margin seems a bit volatile from time to time but never dropped below 6% over the past 10 years (see below).

Source: Morningstar; data as of 5/14/2019.

The share price looks reasonable with a P/E of 14.2x, a P/S of 1.3x, a P/CF of 13.1x, and a dividend yield of 3.3%, in light of their historical averages and analysts' estimate of an almost 10% YoY growth over the bottom line moving forward (according to SimplyWallSt). However, investors should be aware of a possible recession as well as the strong competitors, such as Fastenal (FAST) and W.W. Grainger (GWW), in this space.

Source: Morningstar; data as of 5/14/2019.

Source: SimplyWallSt; data as of 5/14/2019.

Medifast (MED)

Medifast produces, distributes, and sells weight loss and health-related products through websites, multi-level marketing, telemarketing, and franchised weight loss clinics.

The company mainly targets at the $17 billion US weight-loss market with a 5% annual growth. The sales growth has been bumpy for the past decade (see below), turning negative between 2014 and 2015 but revived later since the introduction of the OPTAVIA program.

Source: Morningstar; data as of 5/14/2019.

Meanwhile, the management has demonstrated good capital allocation skills, reflected by the high returns on assets, equity and invested capital (see below) for the past 10 years. The asset turnover and margin has improved dramatically during recent years.

Source: Morningstar; data as of 5/14/2019.

The FCF margin has been stable (around 10%), and the annual capital spending maintained low compared to total sales (below 5%).

Source: Morningstar; data as of 5/14/2019.

Per analysts (see below), the EPS is expected to grow at more than 25% on a yearly basis, driven by the OPTAVIA program and international expansion (Hong Kong and Singapore to start with this year). If that is true, the business would double in 3 years and triple in 5.

Source: SimplyWallSt; data as of 5/14/2019.

With the growth prospect in mind, the stock does appear cheap in today's market with a P/E of 26x and a P/CF of 22x (both roughly in line with their historical averages).

Source: Morningstar; data as of 5/14/2019.

Exponent (EXPO)

Exponent (formerly Failure Analysis Associates) is an American consulting firm with a multidisciplinary team of scientists, physicians, engineers, and business consultants which performs research and analysis in more than 90 technical disciplines. Over 50% of the workforce hold a Ph.D. or M.D. in their chosen field of study.

The company has a great track record of consistently positive sales growths since 2006, even without any decline during the 08/09 financial crisis (see below).

Source: GuruFocus; data as of 5/15/2019.

The management has also been doing a great job in delivering high returns on capital for the past 15 years. However, I do think Exponent possesses a rather narrow moat as the company heavily relies on the expertise of the team (which is relatively easy to replicate, in my opinion) to stay competitive.

Source: GuruFocus; data as of 5/15/2019.

I wrote to the management regarding the durable competitive edge of the business, and below was the reply from the Executive VP and CFO, Richard L. Schlenker -

What makes Exponent unique is our ability to create interdisciplinary teams to provide solutions to our client's most pressing and complicated engineering and scientific issues. We are able to draw upon our 1,000 employee in more than 90 technical disciplines, with over 500 Ph.D.s., and 50 years of experience in analyzing accidents and failures to advise clients as they innovate their technologically complex products and processes, ensure the safety and health of their users, and address the challenges of sustainability. While many client hire us for a single expert in particular discipline it is when the issue becomes more complex that we are the go-to firm.

The industry of engineering and scientific consultancy is fragmented. Exponent faces competitions directly from other providers (especially with lower prices) and indirectly from in-house teams that can perform same services themselves. Nonetheless, clients that have the in-house capability to perform such services often retain Exponent or other independent consultants because of independence concerns.

As the management admitted in their annual report, the barriers to entry in the space are low, and for many of Exponent's technical disciplines, competition is increasing. To tackle competitive forces in the marketplace, the management plans on "looking for new markets for our various technical disciplines," which I think again indicates the narrowness of the moat.

Moving forward, Exponent is believed to benefit from the industry tailwind as technologies become increasingly complex. Some recent projects include assessing virtual reality technologies and evaluating the performance of automated vehicles. Additionally, the geographic expansion would act as another growth engine for the business. In the meantime, investors should be aware of the cyclical risk facing a consulting business like Exponent.

Per SimplyWallSt (see below), the bottom line at Exponent is expected to grow by high-single-digits for the next 1-3 years.

Source: SimplyWallSt; data as of 5/15/2019.

The management recently announced a 23% increase in the quarterly dividend and a $75 million addition to our stock repurchase program, demonstrating the confidence in the company's long-term financial performance.

Currently, the share is traded at the P/E and P/CF of around 40x, both of which are higher than their respective historical averages (see below). P/S and the dividend yield tell pretty much the same story that the stock is overpriced. I would recommend interested investor put EXPO on their watch list and wait for a more favorable entry point.

Source: Morningstar; data as of 5/15/2019.

Summary

I believe that a ranking model or a rigid screener could be a good first step to uncover high-quality but underappreciated stocks. 4 small/mid-cap stocks are introduced and discussed in this article: one recession-proof healthcare name, one cyclical industrial name, one fast-growing consumer product name, and one stable growing business service name. Although I think that they are promising in terms of outperforming the market in the long run, investors should always conduct careful analysis and patiently wait for favorable entry points before investing.

Disclosure: I am/we are long FDS, SEIC, EGOV. 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.