The Little VC Engine That Could

09/15/2010 11:39 am EST

Focus: STOCKS

Ian Wyatt

Publisher & Chief Investment Strategist, Wyatt Investment Research

Ian Wyatt, editor of SmallCapInvestor.com PRO, finds a public company that acts like a venture capital or private equity firm for niche companies—and pays a fat dividend to boot.

Compass Diversified Holdings (Nasdaq: CODI) specializes in acquiring middle-market businesses—those with enterprise values between $50 million and $250 million—and helping management grow the acquired company to ensure a sustainable stream of cash flow.

Since 2007, Compass has recorded gains from the sale of businesses of nearly $110 million. Along the way, Compass pays regular distributions to shareholders in the form of dividends.

This business model may sound familiar to those versed in private equity and venture capital firms—but there is a difference. Compass typically funds operations and acquisitions with cash, and with a dedicated credit facility, rather than through excessive borrowing.

This allows CODI to focus on opportunistic acquisitions without having to adhere to unfavorable financing terms. And it allows Compass to truly work with the managers of the businesses it owns to achieve success, while being the only lender.

It also allows Compass to fulfill its commitment to shareholders—since going public [in 2006,] it has never decreased its dividend. What's more, it gives independent investors a chance to become part owners of the [kinds of] companies that are usually reserved for private equity firms, or family-run operations.

To manage risk, Compass purchases companies in a [variety] of industries so that economic cycles don't adversely impact all companies at once.

Compass is helping each of [its] companies develop successful growth strategies. Currently its valued-added services include help with sourcing, branding, customer acquisition, cost containment, and production strategy.

In the second quarter of 2010, Compass increased revenue by 40%, to $404 million from the second quarter of 2009. A modest loss of $0.7 million was down from a loss of $0.2 million in the [same quarter a year earlier.] Compass won't always turn a net profit after adjustments, because it is actually structured to pay dividends to shareholders [first].

The most important measure of success is cash flow—and in the second quarter, cash flows increased by 90% to $14.8 million from the [same period in] 2009. Compass finished the quarter with $15.1 million in cash and cash equivalents and $73 million in long-term debt. The company has around $200 million in available liquidity.

Compass's revenue and earnings growth should average around 15% over the next two years. That would be solid growth for a company that pays 9% a year in dividends. The near-term down side to this stock will be at its support level of $13.

To the up side, I'm targeting $16.75. This implies a reasonable forward P/E [multiple] of 10.4x expected earnings per share of $1.70 over the coming 12 months.

I recommend you buy shares of Compass Diversified Holdings up to $15.10. (It closed just below $15 Tuesday—Editor.) For the time being, I have set a stop loss at $12.00.

Subscribe to SmallCapInvestor.com PRO here…

Related Articles on STOCKS