Small-Cap Expert's Mid-Year Favorites

06/10/2015 10:00 am EST

Focus: STOCKS

Richard Moroney

Editor, Dow Theory Forecasts

Richard Moroney, editor of Upside, has just released his annual mid-year survey of capital gains favorites. Here, he walks us through the factors he considers when selecting these stocks and reviews the six top picks that made this year's list.

Steven Halpern: Our guest today is Richard Moroney, editor of Upside, an industry leading newsletter focused on small- and mid-cap stocks. How are you doing today, Rich?

Richard Moroney: Good. Thanks for having me, Steve.

Steven Halpern: Well, thank you for joining us.  Each year you publish special reports at mid-year, and at yearend, isolating your capital gains favorites.  Now before we look at the stocks that made the mid-year cut, let's walk through some of the criteria that you look at.  First, you consider outstanding operating momentum.  Could you expand on that?

Richard Moroney: Right.  What we are looking for there is consistent sales and profit growth in recent quarters.  We are also looking for consistent growth in cash provided by operations.  We always want to see cash growing along with earnings.  

In addition to that, we will look at margins.  We're not going to insist that—always—margins are rising, but we do like to see improving margins suggesting that the sales growth is translating into accelerating earnings growth.  

Steven Halpern: Now, you also look for increasingly positive outlook for profit growth. Can you comment on that?

Richard Moroney: Right. That's just the way we phrased it—in terms of—we look for rising profit estimates. We always want to see revisions, in terms of consensus estimates, and also, the number of analysts boosting estimates compared to the number lowering estimates.  We always want those factors to be favorable.  Those are both.several variables related to both those kinds of trends are part of our earnings estimate score, which is part of our quadrics overall score.  

Steven Halpern: Now, you also look for strong share price accent along with reasonable evaluations.  How do you balance those two factors?

Richard Moroney: Well, we measure them separately, with our performance score, we are looking at total returns of periods of up to 12 months is what mostly our performance score is based on.  

While we don't always insist on a superior performance score, if a company is posting good results, has good operating momentum, rising earnings estimates, we'd also like to see the stock outperforming.  We would like to see the stock confirming the strength that we see in the more fundamental variables.  That's how we measure performance.  

In terms of how we measure evaluation, we have a quadrics value score—which is based on about 20 variables—where we look at a lot of the conventional evaluation ratios like price earnings, price sales, price cash flow, and price to free cash flow.  

We also look at those evaluation measures relative to three- and five-year norms, so we will look at what is the PE today, versus the PE over the last 60 months and that's how we measure evaluation.

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Generally, we are looking for a cheaper than average evaluation and a better than average performance score.  We want a stock that's cheap but has not fully discounted, but that is not completely being left behind.  We want it to be cheap but not so out-of-favor that it's going to take a whole cycle for the stock to get back in favor.

Steven Halpern: Now, turning to your mid-year favorites, let's begin with II-VI Inc. (IIVI), a company which happens to use Roman numerals for its name. What's the story here?

Richard Moroney: This is a leading maker of lasers for industrial and aerospace uses.  The company has strong operating momentum.  Posted a very good March quarter, along with these other stocks has rising earnings estimates.  The other thing we like about II-VI—which we like despite its name and ticker symbol which is IIVI—is its cash flow momentum.  

Cash provided by operations is growing faster than profits and that's allowing the company to boost its capital spending and boost its capacity. That's a stock that—while it's not super cheap—given its operating momentum, I think it's pretty cheap.

Steven Halpern: You are also a fan of ICON (ICLR), a contract research organization. What's the outlook here?

Richard Moroney: The outlook is strong.  The company has posted good momentum in terms of order growth.  This is a company that provides contract research for pharmaceutical companies, so drug makers hire Icon to test new and existing pharmaceuticals.  With the number of new compounds coming down the shoot, the company is well positioned there.  

One concern is, the company gets about 34% of its sales from Pfizer (PFE); people are a little bit worried about that. There is some reason to be concerned about that—and they have a large contract with Pfizer expiring—but I think given the history of its relations with Pfizer, given the exposure it has to other clients and the general industry backdrop, I think the stock is a pretty good value at 18 times this year's estimate.

Steven Halpern: Now, the next company we are going to look at is JetBlue Airways (JBLU), which happens to earn your maximum overall rank of 100. That's in your proprietary Quadrix ranking system. How uncommon is this top 100 rating and what do you see ahead for the airline.

Richard Moroney: Well, a 100 is hard to get, basically, because we have one little known thing about the Quadrix score, in their percentile ranks, we do have a zero and we do have 100.  Only, basically, one half of 1% of US companies qualifies to get 100 (we have about 4600 in our ranking system).

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To get 100, you need to have good scores in, really, in all six of the category scores that drive the overall score; that's momentum, when we are talking about recent operating results, value, quality, when we are looking at a company's track record, it's return on assets, return on equity, financial strength, earnings estimates, which I talked about, and performance, which I talked about.  

Those are the six scores, with value being the most heavily weighted.  Those are the six scores that go into the overall score. JetBlue scores above 60 in each of those six categories.  

It's kind of a classic stock to get such a high rating because it's cheap, people are dubious about whether the airline industry can maintain its operating momentum, and it's got good fundamentals on its own.  

Very strong operating momentum.  It's got rising earnings estimates and the stock has been an outperformer, so kind of a classic high scoring stock in our system.  

Steven Halpern: Now, what's the attraction with Wabash National (WNC), which is a supplier of semi-truck trailers?

Richard Moroney: To some extent, it's a very different company than JetBlue, but it's also scoring well because people are anticipating that their industry—construction of trailers for semi-trucks—is near a cyclical peak.  

If you look at past cycles and maybe look just at the operating momentum Wabash has—and even if you assume that things are going to slow—you give all those assumptions, the stock is still pretty cheap.  

It is well positioned relative to its peers. Its gaining market share, its margins are rising.  It's actually turned away some orders for 2015 because its backlog is so full.  It's kind of a classic cyclical.we think it's more like the sixth inning and Wall Street is treating it like it's the ninth inning.  

Steven Halpern: Now, finally, there are two financial stocks that made your mid-year favorite list, Heartland Financial (HTLF) and Western Alliance (WAL). What do you see ahead for these banking firms?

Richard Moroney: Both companies are benefiting from much improved loan growth, both internally and they have made some niche acquisitions.  In particular, Heartland has been pretty aggressive on the acquisition front, making ten acquisitions in the past ten years, including two deals announced this year.  

It has a good record of integrating those acquisitions and it also has good internal loan growth in terms of loan growth excluding acquisitions.  

Western Alliance has relied more on its own operations—without turning to acquisitions as much—but it did recently make a pretty big deal for Bridge Capital, which was announced in March.  I like that deal.  It's going to accelerate their loan growth.  It's going to give us some opportunities to grow into some new areas.  

The stock is not the cheapest bank stock, but its profit estimates are rising and it seems pretty reasonably valued relative to next year's estimates.  I think both those stocks are nice niche players among regional banks.

Steven Halpern: Again, our guest is Richard Moroney, editor of Upside stocks newsletter.  Thank you for sharing your thoughts today.

Richard Moroney: Sure. Thanks for having me.

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