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How strong small caps survive in a weak market

No matter how the market behaves, there are always stocks that will prosper, says this small cap advisory, which points to several winners.

Many people have tried to turn investing into a science, with greater or lesser success. Yet there are times when it looks like little more than a series of emotional outbursts of high anxiety, or unbridled enthusiasm. But of course no science has yet been found that can remove the emotion from human nature.

There are certainly abundant reasons to be anxious in today’s markets. The affects of the credit crisis are all too real, and investors have some hard decisions to make in the months ahead.

But there are also reasons for enthusiasm. People still buy stocks. Smart companies don’t get stupid overnight, even though economic conditions may be working against them for a time. Their share prices may go into hibernation, but they keep on growing and wait for the market to catch up.

Even small cap stocks can swim against the tide in conditions like these. That is the opinion of KeyStone’s Small-Cap Stock Report. You might suppose that this Canadian advisory is simply defending its own turf, but it points to several recent examples of success to make its case. Plus it has a fresh buy for its readers.

The debt markets

The editor of this report doesn’t try to downplay the seriousness of the credit problem. He points to a UBS study estimating that “financial firms worldwide will take debt-market writedowns totaling $600 billion US in the wake of last summer’s liquidity crisis.” Writedowns had reached some $160 billion by the beginning of March.

Consider also the phrase “last summer’s liquidity crisis.” The trouble began over six months ago, and we’re still only about one-fourth of the way through the clean-up.

“In fact, 75 per cent of the world’s financings on this planet are done through the debt markets; if there is a chance that market isn’t operating efficiently, it makes it hard to do much in the equity markets,” says the advisory.

Oil and gold stick like glue

But there are compensating factors in Canada. “Gold and oil continue to stick together like glue offsetting weakness in financials and have helped the S&P/TSX Composite outperform its U.S. counterparts thus far in 2008.”

On the other hand, a drop in exports to the U.S. caused gross domestic product to shrink 0.7 per cent in December, rather than the 0.2 per cent projected in market forecasts. “This should not come as much of a surprise,” says the editor, “as the U.S. economy is in a rough spot at the moment — one might even end up referring to it as a recession.”

And even though Canadian consumers have continued to spend at a brisk pace, the Bank of Canada knocked down interest rates on March 4.

So things aren’t going to be easy. The solution, according to this advisory, is not to throw up your hands, but to choose your stocks very carefully.

Quarter-over-quarter momentum

This advisory illustrates the advantages of careful stock selection with updates on three companies. We reported on these stocks when they were featured by the advisory two months ago (Daily Buy-Sell Adviser, January 16, 2008). The first is a tech stock, which would make many investors nervous right off the bat.

Still, Sangoma Technologies Corporation (TSX/V-STC) recently issued “very strong” second quarter numbers. The company manufactures hardware and software that help the communication between computing devices and Wide Area networks and telephone networks. Among the products it supports are phone cards and lottery terminals.

“We highlight it here as an illustration of a company which appears to have hit an inflection in its growth on a quarter-over-quarter basis,” says the editor. As the company’s products gained acceptance for reliability in the industry, the market for those products began to expand rapidly. Subsequently, it shed the hit-and-miss results that tend to mark the early exertions of emerging companies.

“From the fourth quarter of 2006 onward, the company has shown tremendous quarter-over-quarter sales momentum which culminated in a 147 per cent increase in net income in the company’s recently reported 2008 second quarter results,” explains the report.

“Couple the company’s cutting-edge and reliable products with its solid fundamentals, which include a forward-looking PE of just over $10… and mix in its earnings growth rate, which in the last quarter exceeded 100 per cent, and we continue to believe that the stock is undervalued,” concludes the advisory, “and it remains on our Focus BUY list for further mid-term growth.”

This advisory began following the stock in December 2005 when it stood at $0.33. It made it a buy last year at $0.96. The shares rose to $1.18 at the time this report was published, and opened today at $1.29.

The infrastructure trade

The other two stocks this advisory points to as success stories are in the infrastructure trade. There don’t appear to many more lucrative gigs these days than building or repairing structures around the globe.

These two smaller Canadian firms are a perfect example of how to succeed in infrastructure. Empire Industries Ltd. (TSX/V-EIL) is a steel fabricator and construction services firm handily located in the booming western Canadian market.

Empire recently announced that its B.C. subsidiary had been awarded at $21 million contract to make and install the Coast Meridian Overpass for engineering giant SNC Lavalin (TSX-SNC). “Empire has more than tripled its capacity in the past 18 months,” says the report, “and has been actively pursuing additional work to utilize this capacity.” With this new contract, Empire’s backlog stands at $101 million.

The advisory first picked up the stock last year at $0.43 and has been “pleased with the progress of the shares recently closing in the $0.56 range, up 30 per cent this year.” They opened today at $0.52.

Global Railway Industries Ltd. (TSX-GBI) isn’t directly involved in building infrastructure, but it does provide products and services to railway suppliers, like hydraulically controlled railgear, even recorders, railcar doors and replacement parts.

“While not a pure play on the infrastructure market, it provides good exposure to the North American railroads and commuter system markets which, after years of neglect, are in need of an overhaul,” explains the report. This stock is trading at $4.48.

Quick-serve fast food

Not all small caps have survived so well, of course, nor would KeyStone’s Small-Cap Stock Report pretend otherwise. But since its track record on select stocks seems pretty reasonable, let’s take a look at one stock that it has brought on board as a fresh buy.

This one is in the fast food business. MTY Food Group Inc. (TSX/V-MTY) franchises and operates quick-serve restaurants (“quick-serve” appears to be a euphemism for the somewhat discredited “fast food”). They can be found in shopping malls, food courts, office towers, cinemas, universities, hospitals, amusement parks and just plain old street corners around the country.

Many of the names will be familiar: Mrs. Vanelli’s, Thai Express, Tiki Ming, Pannini Pizza Pasta and Yogun Fruz. These are not the Burger Kings of the world, but there are a lot of them. 76 per cent of the franchises are in Ontario and Quebec, 11 per cent in western Canada, four per cent in the Maritimes and three per cent outside the country.

“MTY Food Group has successfully applied its business model to capture the increasing demand for fast-food service resulting from today’s on-the-go lifestyle,” says the report. MTY develops its own banners and acquires existing names from elsewhere. Between 2004 and 2008, the number of outlets it runs virtually doubled from 420 to 825.

To keep its revenues growing, the company must keep the number of franchises growing — which it is doing. One area of expansion is geographical, as in a recent agreement with a Middle East restaurateur to open 93 additional franchise stores in the region. Or in the opening of more Sushi Shop locations in Ontario and Quebec.

The fiscal results have been consistently good. MTY recently reported its year-end figures, with net income up 58.2 per cent and revenues up 39 per cent.

Commenting on the strong results, the advisory says: “Management has a wealth of experience in the industry and has shown that they are very adept at growing revenue and completing acquisitions without ignoring the bottom line. The stock trades at higher multiples than our normal picks, but this is justified by its past and future growth.”

The stock has been on an upward trend of late, though it has fallen off a bit recently in the re-agitated markets. It stood at $11.35 when this report was issued. It opened today at $10.00.

Prosperity may be a little harder to find in the markets today, and that goes double for small cap stocks. But that doesn’t mean everybody has to pack up and go home. The secret is to make very rational picks — and not get too emotionally attached to them. Or perhaps the real message with small caps is: if you’re not afraid of failure, you just might find success.