Five Favorites in the Small Cap Arena

08/01/2019 5:00 am EST

Focus: STRATEGIES

Richard Moroney

Editor, Dow Theory Forecasts

For more than 20 years, we have scoured the market for the best small and mid-cap stocks, rating only our 12 to 20 favorites as Best Buys, explains Richard Moroney, editor of Upside.

This focused approach has served us well over the years. At the midway point on 2019, our Best Buy List is up 21%, while the broader Buy List is up 16% and 10% for the S&P SmallCap 600 Index. Here's a look at our five of our top picks for capital gains over the next 12 months

Ciena (CIEN)

A leading maker of networking gear, Ciena is projected to increase per-share earnings by 44% this year and by 23% in 2020. Strong demand for its optical gear, which carries video, data, and voice traffic across fiber cables, reflects robust capital spending by AT&T (T) and Verizon (VZ), the company’s largest customers.

Product rollouts are helping drive growth, and Ciena is gaining market share at the expense of smaller optical equipment vendors. Management offered a bullish long-term outlook, saying per-share earnings should increase more than 20% annually.

For fiscal 2019 ending October, Wall Street targets per-share earnings of $2.00, above the consensus of $1.83 just one month ago. Revenue is expected to hit $3.5 billion, up 14%. A midyear capital-gains favorite, Ciena is rated Best Buy.

Atkore International (ATKR)

Atkore makes products that are primarily used in the construction market, which continues to enjoy upbeat sentiment. It makes electrical-raceway products, the fittings and trays that protect wires and cables from heat, corrosion, and water.

The U.S. accounts for 90% of total sales. The stock earns the maximum Quadrix Overall rank of 100, supported by scores exceeding 80 for five of six categories. Atkore’s middling Financial Strength rank is partly due to its heavy debt load and low profit margins. But its profit margins are steadily improving.

Consensus per-share-profit estimates are marching higher for both 2019, projected to grow 20%, and 2020, 6%. The shares trade at just eight times estimated 2019 earnings, versus a median of 16 for the S&P 1500 Index industrials sector. Atkore is a Best Buy.

Diodes (DIOD)

After struggling for most of 2019, Diodes shares are starting to find their stride. Analyst estimates are rising, with the consensus projecting 29% profit growth for the June quarter and 21% growth for the year.

Diodes should get a boost from wireless carriers building their 5G networks, the next generation of cellular connections. The company is supplying components used in base stations and cellular equipment attached to streetlights and utility poles.

At just 13 times trailing earnings, the shares trade below the median of 19.5 for S&P 1500 Index semiconductor stocks and their own five-year median of 24.

 If Diodes meets the 2019 consensus profit estimate of $2.87 per share and its trailing P/E ratio climbs to 15, the shares would reach $43 over the next seven months. The company has topped consensus profit estimates in each of the past four quarters. Diodes, earning the maximum Quadrix Overall score of 100, is rated Best Buy.

Generac (GNRC)

Generac shares have been on a tear, climbing 39% over the past three months. The shares still look cheap, earning a Quadrix Value score of 61 and trading below peers and their own historical norms for both trailing earnings and estimated 2019 profits.

Generac makes residential power generators and backup-power systems for U.S. wireless carriers. With the 5G rollout, Generac expects an extended investment cycle from wireless companies that could continue for the next couple years.

Additionally, Generac anticipates higher demand for residential power generators in California as utility PG&E limits electric distribution during extremely dry and windy conditions to reduce the risks of another major wildfire.

Although operating profit margins expanded in five of the past six quarters, Generac’s profitability could get squeezed from the U.S. trade war with China. Generac is a Best Buy.

Hexcel (HXL)

Hexcel produces carbon fiber materials, found in aircraft, satellites, and turbine blades. Lighter and more durable than aluminum, carbon fiber helps reduce operating and maintenance costs.

The shares aren’t cheap, trading at 21 times trailing earnings, versus a median P/E ratio of 18 for aerospace and defense stocks in the S&P 1500 Index. But we’re willing to pay up for the stock, given Hexcel’s growth prospects.

Looking out over the next three years, management sees annual pershare profits climbing by double digits. Hexcel targets three-year annualized sales growth of 4% to 7% in the commercial-aerospace market (69% of sales for the 12 months ended March), 11% to 13% in space and defense (17%), and more than 10% in industrial (14%).

Free cash flow is expected to total $1.8 billion over the next five years — more than five times higher than what Hexcel generated in the past five years. For the 12 months ended March, free cash flow rose 20% to $169 million. Hexcel is a Best Buy.

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