Small-Caps Remain Your Best Speculative Bet

 | Jan 28, 2013 | 2:00 PM EST
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Despite a magnificent surge in small-cap stocks since 2009, I believe that the best opportunities in today's marketplace still remain with the smaller issues in the stock market.

These small-caps opportunities remain because of the nature of Wall Street. There is a structural disadvantage to size. A fund that manages $10 billion cannot invest in businesses that have market caps below $2 billion. If that fund were to allocate 3% of its assets, or $300 million, to a $2 billion company, the fund would acquire 15% of that company, and that would be a highly unattractive bet for a couple of reasons. First, to buy 15% of any company in the open market would create a substantial advance in the price of the stock. Secondly, most investment funds need to own positions that can be readily disposed of without price disruption.

Since most investment dollars are controlled by the mega funds, the probability of price inefficiencies in securities increases as market capitalization decreases. Today's market level ensures that the pool of quality investment ideas continues to shrink, but as we look across the spectrum of stocks, the smaller names continue to offer the most intrigue.

Retailer ALCO Stores (ALCS), a microcap stock that I wrote about as a long-shot investment idea a few months ago, is anything but a long shot now. ALCO operates 216 general retailers, most of which are located in small towns that have little chance of Wal-Mart (WMT) or Target (TGT) stepping in. ALCO generates $500 million in sales per year, and current profit margins are depressed; this creates huge potential for improvement. At a $26 million market cap, such an improvement is likely to catapult shares higher.

After a laggard 2012, Sterling Construction (STRL) once again shows signs of life. As the economy continues to improve, Sterling's infrastructure construction business will benefit as an improving economy eventually benefits state and federal transportation spending. Sterling has no debt and sits on cash that's equal to a third of its market cap at the current $10 stock price.

In today's market, even a $3 billion business is considered small, according to many investment standards. That's why Gentex (GNTX), at $19 a share and a market cap of $2.7 billion, remains of the most intriguing ideas today. The most innovative technology company serving the automotive industry, Gentex sells more than 80% of today's rearview mirrors. It produces not just plain rearview mirrors but those that have automatic dimming technologies, cameras and other safety features that are becoming standard in today's vehicles.

Several months ago, Gentex's shares were trading over $30, and it's only a matter of time before the stock reaches newer highs. Gentex, for as far back as I've gone, has never used debt, and that tells me a lot about management's DNA. Unlevered return on equity equates to 16%, and the company kicks back a decent 2.7% yield. To a private owner, Gentex is perhaps worth $4 billion or more.

By design, Wall Street is built to focus on the biggest, fastest-growing and most popular names, since those are the most marketable issues. Small-caps and even micro-caps, despite becoming more popular over the past decade, will always continue to provide the greatest market inefficiencies and thus the greatest potential for above-average returns.

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