The US small-cap market is immense, with over 1,600 domestic companies falling in the traditional $100m to $1bn market capitalisation range, according to Morningstar data. Relative to the FTSE All-Share index, the US small-cap market is more heavily weighted toward the technology, healthcare, and industrial sectors, making it fertile ground for UK investors keen on diversifying their small-cap holdings.
Given the breadth of the market, there are plenty of opportunities for deep value and high growth investors, as well as investors seeking steady dividend-paying shares. The following 10 companies have various growth and risk profiles, but each appears to possess - or is on the way toward possessing - an economic moat that could allow them to sustainably create shareholder value.
It's important to separate economic moats from the often used term 'competitive advantages'. Each company will of course say that it has competitive advantages, but the key difference is whether or not those advantages are defendable and will enable the company to generate returns above its cost of capital over longer periods of time.
To illustrate the difference in terms, consider the tale of eBay versus Groupon. eBay has stood the test of time by leveraging its online auction technology and creating a classic 'network effect', whereby the value of the network increases as each new member is added. Anyone looking to sell their goods online will want to go where there are the most buyers and eBay's dominant presence in the online auction and marketplace industry makes it difficult for would-be competitors to enter the market and prosper. Groupon, on the other hand, had a lot of initial success by being an early-mover in offering online deals-of-the-day, but the business model was highly replicable and much larger Facebook and Google quickly moved in and removed any temporary competitive advantage Groupon had in the space.
Other sources of economic moats are intangible assets (eg, valuable brands or patents), cost advantages due to favourable scale or access to unique assets, switching costs that make it expensive for customers to easily change providers, and efficient scale, which typically features companies operating in rational oligopolies or in niche markets. Companies that do not fit into one of these five categories are unlikely to possess a true economic moat and thus may be unable to sustainably earn high returns on capital.
As you might imagine, companies with economic moats have, as a group, performed quite well. In the 10 years ending in 2012, for example, Morningstar's Wide-Moat Focus index generated 13.7 per cent annualised returns versus about 7.1 per cent for the S&P 500. When analysing potential long-term investments, then, it's extremely valuable to consider whether or not a company either currently possesses an economic moat or is currently digging one. Most small caps will fall into the latter camp, so investors may need to look ahead a few years to consider whether or not smaller companies are on their way to establishing a bonafide moat. It's important to note that the US small-cap market has had a good run over the past year and some of the companies on this list have rallied quite strongly while others have lagged the market. Historically, US small caps have been highly dependent on the domestic economy, and while that certainly remains true for some companies in the space, many others have followed the paths of larger peers by branching out overseas. So, even if the US economy cools a bit, small caps with significant overseas exposure may remain compelling growth stories.
That isn't to say that the ride won't be a bit bumpy in the event of a weaker US economy, but high-quality small-cap companies with burgeoning competitive advantages - purchased at a good to fair price - should reward patient investors.
As always, it's critical to do your own research prior to investing in any share. Hopefully, this list will provide a number of solid ideas for your watchlist.
1. US Ecology (Nasdaq: ECOL)
Share price: $27.81
Market capitalisation: $507m
Dividend yield: 2.6 per cent
Trailing price-to-earnings: 19.1
Few start-ups are eager to break into the hazardous waste industry. Aside from the unpleasant nature of the business, start-ups would face significant up-front environmental and compliance costs that may deter their entry. Furthermore, few customers would be willing to take a chance on a company that lacked a proven track record of handling large waste remediation projects. Consequently, the established North American hazardous waste and landfill operators, including US Ecology, have a structural advantage that should allow them to sustainably generate returns above their cost of capital.
One particularly attractive attribute of US Ecology is that, unlike some of its larger competitors such as Waste Management and Clean Harbors, the company is a pure-play in the specialised and valuable hazardous waste market. US Ecology has also been a consistent generator of free cash flow, has maintained a tidy balance sheet, and currently features a dividend yield of 2.6 per cent, which is relatively high by US small-cap standards. These features should help offset some of the natural revenue volatility that comes with the company's large and often non-recurring special waste projects. Two risks to be mindful of are, first, that the company has undergone a number of senior management changes in the past year, and, second, that the frequency of bolt-on acquisitions has increased, perhaps indicating slowing organic growth opportunities.
2 iRobot (Nasdaq: IRBT)
Share price: $31.33
Market capitalisation: $848m
Dividend yield: na
Trailing price-to-earnings: 34.9
Unlike most 'i-products' in the market today, iRobot was not named to ride the coattails of Apple's iPod/iTunes/iPhone product lines. In fact, iRobot came into being more than a decade before the first iPod emerged. The company was created by three MIT roboticists in 1990 (one of whom is the current chairman and chief executive) and has since sold over 8m robots, which perform various tasks ranging from cleaning floors (Roomba) to safely disposing bombs (PackBot). Approximately 90 per cent of iRobot's revenue comes from its Home Robots division, with the balance coming from its Defence & Security division.
iRobot's PackBot (top) and Roomba (below)
Competitors do exist in certain areas of iRobot's business - including UK-based QinetQ - but it is unlikely that throngs of amateur roboticists can quickly become formidable like-for-like competitors. For one thing, they'd have a hard time getting around iRobot's library of patents, which the company has vigorously and successfully defended over the years. iRobot's earliest major patent does not expire until 2019. In addition, iRobot spends over $35m a year on research and development, which helps the company maintain its technological advantages. Indeed, iRobot has managed to increase average selling prices per home robot unit for the past five years.
Investors concerned about potential volatility in demand for home robots might take some comfort in the fact that iRobot carries no debt and has almost $5 a share in cash.
3. Winnebago (NYSE: WGO)
Share price: $19.56
Market capitalisation: $540m
Dividend Yield: na
Trailing price-to-earnings: 9.5
The great American road trip has been immortalised in movies such as Easy Rider, Little Miss Sunshine, and Dumb and Dumber. And with nearly 80m Americans born in the 'baby boomer' generation quickly approaching retirement age, it's likely that more people will seek their own adventures on the open road in the coming years. There are about 9m recreational vehicles (RV) – also known as motorhomes - on the road in the US today, built for just this type of holiday.
Winnebago has been on a strong run over the past year.
During the dark years of 2008 and 2009 when annual RV sales were halved, a number of manufacturers went out of business, leaving the surviving companies with an opportunity to capitalise on the sharp (but still-in-progress) recovery. One of the survivors is Winnebago, which currently has the number two position in the now-consolidated industry. The new industry dynamics have increased the cost to enter the market, as a would-be competitor would need to cultivate relationships with RV dealers and match incumbents' high research and development investments to deliver the premium features today's RV buyers want, such as vaulted ceilings and entertainment centres.
One of the main reasons that Winnebago survived the financial crisis was its debt-free balance sheet and conservative capital allocation. The company has been on a strong run over the past year, so this may be a solid name to consider in the event of a market pull-back.
4. Badger Meter (NYSE: BMI)
Share price: $44.54
Market capitalisation: $642m
Dividend yield: 1.5 per cent
Trailing price-to-earnings: 25.9
Just as the Tube's electronic turnstiles let Transport for London know how much to charge each rider, Badger Meter's flow-measurement technology similarly helps utilities know how much to charge their customers. The majority of Badger Meter’s customers are water utilities, although its products are also used to a lesser degree in the natural gas, food and beverage, and pharmaceutical industries.
Badger Meter's flow measurement equipment is typically mission-critical, so it's unlikely that customers will be keen on switching measurement equipment providers based on price alone. Instead, quality, reliability and service are more common considerations, making it difficult for upstart competitors without a solid reputation to enter the market. In addition, the company's research and development budget usually ranges between 2.5 per cent and 3 per cent of its annual sales - a significant amount that helps Badger Meter maintain its technology lead over competitors.
Although its dividend yield of 1.5 per cent isn't a major reason to invest in the shares, investors should appreciate that Badger Meter has increased its dividend in each of the past 20 years.
5. VASCO Data Security International (Nasdaq: VDSI)
Share price: $8.49
Market capitalisation: $329m
Dividend yield: na
Trailing price-to-earnings: 19.6
It seems that just about every website now requires a password log-in, thus requiring users to keep track of myriad user names and passwords. Perhaps that's why we're prone to using easy-to-remember (and equally easy-to-hack) codes such as perennial favourites 'password' and '123456'. With more and more of our precious data now being stored online, however, simple passwords like this simply won't do.
Enter VASCO Data Security, which is the world's leading producer of user authentication and electronic and digital signature systems. You may already have one of VASCO's authentication products in your wallet - a growing number of banks, such as HSBC and Citibank, distribute the company's DIGIPASS authentication cards, which generate a series of numbers for customers to use when logging into their banking sites as an additional level of security.
VASCO is currently highly dependent on continued demand from the banking sector, which accounted for 81 per cent of its revenue in 2012. Its customer base is also fairly concentrated, with the top 10 customers accounting for 37 per cent of total revenue. But VASCO is looking to diversify its revenue base by creating a site from which consumers can securely log in to their commonly-used websites without having to remember passwords for each one. Time will tell if this venture will work, but it's worth noting that the chief executive owns over 20 per cent of shares outstanding and the company has a net cash balance of $104m.
6. Pacer International (Nasdaq: PACR)
Share price: $6.20
Market capitalisation: $221m
Dividend yield: na
Trailing price-to-earnings: 37.7
Intermodal marketing company (IMC) Pacer International was nearly another casualty of the financial crisis, but has since revamped its business model, restacked its management team and repaired its balance sheet, making it an attractive share to keep on your turnaround watchlist. IMCs such as Pacer are generally asset-light operations, meaning they lease rather than own most of their shipping containers, and help manufacturers transport their goods across long distances by providing container space on rail lines and trucks and assisting with the transportation logistics. This saves manufacturers the time and hassle of planning transportation routes, tracking goods in transit, as well as having to negotiate prices with bulk shippers.
Concurrently, the shipping companies prefer working with IMCs because they consistently purchase large amounts of cargo space and aggregate what would otherwise be fragmented demand. As such, IMCs are generally able to obtain better prices from shippers than a small manufacturer with uneven transportation demands. This allows IMCs to pass on the cost savings to customers.
Since this is a mutually beneficial partnership for the three parties involved, the larger an IMC gets, the stronger the benefits from the 'network' become. If Pacer is able to maintain its growth trajectory, and with a little help from the North American economy, there's a good chance that its economic moat will widen over time.
7. National Presto Industries (NYSE: NPK)
Share price: $76.90
Market capitalisation: $537m
Dividend yield: 1.3 per cent (regular dividend)
Trailing price-to-earnings: 13.8
When I first heard the name National Presto Industries I thought the company might produce magician supplies. The last thing that jumped to mind was a company that made waffle makers, tear gas grenades and adult incontinence products - and all under one roof, no less. But, alas, these are just a few of the products that National Presto Industries makes in its household/small appliance, defence, and absorbent products segments.
National Presto's balance sheet is debt-free and has $93m in cash and equivalents as of December 2012. It’s also generated positive free cash flow in eight of the last 10 years and posted an average return on equity of 12.3 per cent over that period. Income-minded investors will appreciate that the company has paid a dividend for 69 years in a row and is keen on paying substantial special dividends each year to augment its $1.00 a share regular dividend.
In addition to its solid financials, National Presto covers a number of traits that I look for in an intriguing small-cap play. Taking a page from Peter Lynch's "13 signs of a great stock", National Presto checks off at least six of the attributes: it has a dull name; it does something dull (makes kitchen appliances); it has little analyst coverage (just one sell-side analyst officially covers it); it does something disagreeable (defence); there’s something depressing about it (adult incontinence); and insiders have been buying (albeit modestly).
Interested investors should bear in mind that the defence segment typically accounts for the bulk of the company's annual profit and is the most competitively advantaged of the three segments. Any material change in US defence spending could thus adversely affect National Presto's business.
8. Nathan's Famous (Nasdaq: NATH)
Share price: $48.97
Market capitalisation: $223m
Dividend yield: na
Trailing price-to-earnings: 3.1
Fans of competitive eating will recognise the name Nathan's from the annual hot-dog eating contest in New York that bears its name. In 1916, the company started out as a humble nickel hot dog stand on the Coney Island boardwalk, but its prices were so low that passers-by worried that the meat must have been inferior quality and thus shied away from the stand. The founders came up with an ingenious plan to hire people to dress up as doctors in lab coats and eat hot dogs in front of the stand to reassure potential customers that the hot dogs were safe to eat.
In fiscal year 2012, Nathan's generated over $66m in revenue and over $6m in net profit
The company's come a long way since its nickel hot dog days: in fiscal year 2012, Nathan's generated over $66m in revenue and over $6m in net profit. It generates business through a number of channels including its five fully-owned restaurants, 308 franchised units in 27 US states and seven foreign countries, branded products sold in grocery stores, and through third-party restaurants. Although the food products business in intensely competitive, Nathan's growing brand presence could help it gain considerable influence over suppliers and build scale advantages.
9. WD-40 (Nasdaq: WDFC)
Share price: $55.54
Market capitalisation: $861m
Dividend yield: 2.2 per cent
Trailing price-to-earnings: 22.4
One way that companies can produce higher profits is by building upon existing brands and products. Often referred to as 'economies of scope' by academics, this process can help companies realise lower per-unit costs and generate stronger returns on capital. WD-40 is a classic example of a company that has capitalised on this principle. WD-40, which stands for 'Water Displacement perfected on the 40th try', was created in 1953 by three people looking to create a rust-prevention solvent for the aerospace industry. Little could that group of three have imagined that its single secret formula would 60 years later be used in 187 countries and found to have had more than 2,000 uses - from fixing squeaky hinges in the house to lubricating tank ignition systems.
Since so many of its products are based on the WD-40 formula and widely-recognised brand, the company does not need to spend heavily on capital investments or research and development to maintain its market leading position. According to Morningstar, WD-40’s average return on invested capital over the past decade has been 12.9 per cent; perhaps more importantly, that figure hasn't fallen below 11 per cent since 2004, which speaks to the company's ability to consistently generate attractive returns.
10. Stamps.com (Nasdaq: STMP)
Share price: $35.99
Market capitalisation: $547m
Dividend yield: na
Trailing price-to-earnings: 19.5
The US Postal Service (USPS) has made a number of headlines in recent years, most of them not for positive reasons. Declining first-class mail volume, expensive retiree health benefit costs, and fierce competition from UPS and FedEx for express packages all contributed to a reported loss of $15bn (£9.8bn) for the agency in 2012. But there is still good money to be made in selling USPS postage online, as evidenced by Stamps.com's 2012 revenue and operating profit, which increased 14 per cent and 40 per cent, respectively, compared with the prior year.
Small companies with a '.com' in their name may worry some investors who remember the boom and bust of similarly-named companies a decade ago. Unlike most of those dot-com busts, however, Stamps.com actually generates a profit and has dug itself an economic moat to keep potential competitors at bay. One source of Stamps.com's advantage is its valuable approval from the USPS – a regulatory process that would take a competitor over two years to acquire. It is only one of three approved PC postage vendors and the USPS hasn't approved a new one since 2000. Since there are limited options for the growing number of business owners that want to purchase their postage on-demand, Stamps.com benefits from low customer churn rates and receives high-margin recurring revenues from the monthly fees paid by subscribers. As of March 2013, Stamps.com had no debt and a cash pile of $57m.
