Five Promising Small Caps

07/09/2004 12:00 am EST

Focus:

Paul Tracy

Editor, The StreetAuthority Market Advisor

In a special report on small caps, Paul Tracy, editor of the StreetAuthority Market Advisor highlights "five small companies with enormous long-term potential, while posing reasonable risk." Here's a look at his latest favorites.

"We have looked for companies that are beneficiaries of positive long-term secular trends, not just cyclical economic recoveries. These companies have the potential to get in on the ground floor of a major multi-year trend and are better able to ride out inevitable economic downturns. Each is a profitable firm with established businesses. Meanwhile, the key to investing in small-caps is diversification. Remember that only a few big winners can make up for scores of the inevitable disappointments. The best way to play the small-cap space is to put a small investment into a number of different plays. With that in mind, here’s a closer look at a diverse group of our favorites:

"Lighter than metal and more heat resistant than plastic, advanced ceramic materials are finding myriad uses in high-tech modern-day products. Ceradyne (CRDN NASDAQ) holds a number of key patents on ceramic materials. By far the company’s most important market is defense, more specifically, the US military, which has been buying ceramic body armor as quickly as it can be manufactured. Ceramics are also used in missile nose cones, which carry a great deal of sophisticated electronic equipment and need to be extremely tough and heat resistant. Ceramics are the ideal choice for these applications. Ceradyne’s five-year revenue growth rate has topped 30%, yet the company still trades at a forward p/e of just a touch over 20. That gives the stock a PEG ratio of under 1 - cheap by any measure. Add to that a debt-free balance sheet and CRDN looks very compelling.

"One of the most attractive things about the slot machine business is that it’s a recession-resistant growth market. In addition, the industry is benefiting from changing laws around the nation, as many states are now opening up new markets to gambling. Alliance Gaming (AGI NYSE) designs a wide variety of gaming machines under its Bally Gaming label. Despite strong prospects for long-term growth and expansion into new markets, Alliance's shares have taken a tumble in recent trading due to lower earnings guidance and recent news that some states have delayed law changes that would allow slots to be installed in new locations. Looking at the longer-term picture, however, we believe Wall Street has overreacted to the news. Eventually, in an effort to boost state tax revenues it’s clear that several states will relax gambling laws. Trading at only 16 times forward earnings estimates and with long-term growth close to 20%, Alliance is already priced for the worst-case scenario.

"Anyone who has ever purchased a house or condo knows that closing the deal is a document-intensive process. Stewart Information Services (STC NYSE) sits at the heart of all this paperwork. Stewart does all of the background research necessary to establish a title’s validity and also offers title insurance. Ultra-low financing rates have powered a rapid increase in real estate transactions over the past few years. Increased transaction volume spells more business for Stewart. But recently, growth has hit some temporary speed-bumps, handing investors an excellent opportunity to jump aboard at attractive valuations. Even though real estate is a cyclical business, over the long run the domestic real estate market is almost certain to grow. The firm's recent earnings slump has made the stock cheaper than ever. In fact, STC now trades at less than 5 times trailing earnings. The future slowdown in refinancing activity is likely already priced into this stock, making it a great buy.

"A car is stolen every 25 seconds, adding up to 1.2 million vehicles per year worth over $8 billion. And there are more professional car thieves in this country than ever, who are stealing cars and stripping them for parts. Lojack (LOJN NASDAQ) makes a small device that can be concealed in a car. When a car is stolen, police can track the signal and locate the missing vehicle. Most police departments nationwide are capable of detecting the signal from Lojack. What's more, the unit is also starting to gain acceptance abroad. Already over 100,000 vehicles have been recovered using the technology. Recent earnings results have been solid. Company earnings growth topped 60% in the most recent quarter amid rising profit margins. In addition, the stock remains cheap relative to its long-term prospects, trading at only 11 times forward earnings and with a long-term growth rate topping 15%. With all of these factors in mind, LOJN is definitely a small-cap firm with a lot of promise.

"Although hospice care isn’t a pleasant topic, it’s certainly a necessary service. Odyssey Healthcare (ODSY NASDAQ) operates a chain of about 68 hospice facilities in 29 different states, all of which are certified by the Medicare program. And while Odyssey provides some care at its facilities, most patients are treated in their own home. Revenues were up over 40% in the first quarter of 2004 as the company hit a new record in terms of patient admissions. On the acquisition front, Odyssey has been active in recent quarters. There are definite economies of scale to be exploited in the hospice business, as the company is able to centralize billing and staffing decisions. There is one major risk - namely a change in the nation’s Medicare reimbursement policies, as any changes here could adversely impact the stock. However, trading at less than 16 times forward earnings and sporting a debt-free balance sheet, Odyssey appears to have an excellent risk/reward profile."

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