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How small caps grow up to be blue chips

A progress report on a Canadian stock that has steadily made itself better and bigger, here and in the challenging American market.

For those who like to buy stocks for the long term, few stories are better than that of a stock that you can buy when it’s small and keep ‘til it’s much, much bigger.

What follows is the story of one such stock. Since it made its first appearance as a publicly-traded company in 1993, Richelieu Hardware (TSX-RCH) has marched from strength to strength. The company is a manufacturer and wholesale distributor of specialty hardware. (You will never see a “Richelieu Hardware” awning on the street; it is not a retail operation.)

Richelieu has just received a promotion from one of the most prominent advisories on Canadian equities, The Investment Reporter. And therein lies a tale of growth.

Average is a step up

The Investment Reporter has what it calls a “quality ratings system,” a method by which it can assess the general level of risk a stock represents for investors over the long haul.

The size of a company’s assets are the basic measuring stick for the five categories of risk — Very Conservative, Conservative, Average, Higher Risk and Speculative. On the upper end, assets greater than $1.5 billion get you the most stable rating. Less than $75 million makes you Speculative.

Four years ago, when the advisory first placed Richelieu on its list of Key Stocks (core holdings for Canadian investors), it was ‘Speculative.’ Less than a year later, the stock was upgraded to ‘Higher Risk.’

But total assets aren’t the whole story. The advisory refines its ratings by analyzing “a company’s economic sector, capital structure, long-term prospects and so on. We look at its earnings history and how well it has done in business setbacks.”

As it turns out, Richelieu earns a promotion on both fronts. Its assets have grown to $245 million, which rates a step up to ‘Average.’ But so does its pattern of good business behaviour.

Calgary or Nashville

Richelieu’s most recent quarterly results, released in March, marked its 45th consecutive quarter of growth in sales and earnings. That’s more than 11 years, if you’re counting. In each of those years, revenue and cash flow have risen as well.

And all of those figures are projected to rise again this year. Plus, in 2002 Richelieu reached another stage in its march to solid corporate citizenship when it issued its first dividend, six cents a share. It is now 28 cents a share.

For many years, Richelieu remained a relatively small Quebec operation. But now you could go to work for the company in Calgary or Nashville (where it recently purchased Village Square Cabinet Supply). In fact, Richelieu’s ability to establish itself in the American market — a process that baffles so many Canadian firms — is no small part of its onward-and-upward story.

The company has changed in one aspect: it now devotes more than 95 per cent of its business to wholesale distribution rather than manufacturing. Many of its customers are manufacturers, some are hardware retailers; most important, it has more than 37,000 of them.

You may or may not choose to invest in Richelieu (just for the record, the share price is just over $24.00, its price/earnings ratio is 17 and it trades at a little more than 14 times estimated 2008 earnings).

The point of this exercise is to highlight what is virtually a textbook case of how small caps grow into large caps. You would be hard-pressed to find an area in which Richelieu has put a foot wrong — in its products, management or planning.

It is also true that if you had bought the stock at any time over the past decade, you would have built yourself some tidy profits.

A bank and three trusts

While we have The Investment Reporter in front of us, let’s take a look at a few more of the advisory’s most recent recommendations.

The first-half results of the Bank of Montreal (TSX-BMO) were marred by commodity trading losses and restructuring charges. But, says the advisory, “it often pays to buy the laggard of the five big banks.” So this bank is a buy for long-term gains and rising dividends.

An income trust also gets thumbs up. Although an early spring strike hurt production, Labrador Iron Ore Royalty Income Fund (TSX-LIF.UN) is a buy. High iron ore prices are going even higher and “strong steel markets, especially in Asia, means that Iron Ore Company can sell all it can produce.”

Two other trusts, Precision Drilling Trust (TSX-PFD.UN) and TransAlta Power L.P. (TSX-TPW.UN) don’t fare as well. Precision sold off many of its best assets to become a trust, and TransAlta can’t convince the market it can sustain an 80-cent-a-unit cash distribution. Both are holds.

Not all equities can expect strong report cards as they make their way up the ladder of corporate growth. But if you find a growing stock with a steady stream of good grades, it may be you who takes home the prize.