Stirring the Small-Cap Pot

 | Jan 29, 2015 | 1:00 PM EST
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Stock quotes in this article:

vec

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egy

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XLS

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nwy

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twmc

This week we have been using the combined theories of Robert Novy Marx of Rochester University and Cliff Asness to look for high quality small-cap stocks. We have talked about the general idea of the approach and looked at a few stocks that fit the general definition of the combined approach.

We then started adding factors that were known to improve performance and I looked for stock with strong earnings and price momentum that fit our small company value thesis. I looked on Wednesday at the small high quality stocks that pay a nice dividend and might help yield- starved investors collect the cash they need.

Today and Friday, we return to  my wheelhouse and start looking for those small-cap quality stocks that fall into the deep value classification. I am going to start with what my friend Toby Carlisle calls the acquirers ratio.

In his excellent book published last year, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, Toby lays out the cases for using the enterprise value to  earnings before interest, taxes, depreciation and amortization ratio to identify undervalued stock. He points out, as I have in the past, that this ratio is the one most favored by private equity and leveraged buyout investors to identify undervalued companies.

I combined this ratio along with the high quality definition and found some really interesting stocks worth consideration. Vectrus (VEC) provides infrastructure asset management, logistics and supply chain management, and information technology and network communication services to the U.S. government. They manage physical assets, IT network and communication system and military base maintenance and operation services to the US military.

The company was spun off from Excelis (XLS) last year, and like many spinoffs appears underpriced. The company produced gross profits of $135 million in the past months with just $248 million of tangible assets. Right now the $294 million market cap company has an EV/EBITDA ratio of 2.9, so it is cheap based on the acquirers ratio right now.

Any list of cheap stocks is going to have some energy names right now. VAALCO Energy (EGY) makes the grade as a high quality cheap stock right now. The company has operations in Gabon and Angola and is exploring for oil and gas in Equatorial Guinea, West Africa. Closer to home they have both conventional and unconventional operations in Montana, South Dakota, and North Texas.

The $331 million dollar company produced $115 million of gross profits using just $362 million of assets and the EV/EBITDA ratio is just 2.26. We all know that energy could be a very bumpy ride right now but this stock is cheap and when energy recovers it could a lot higher.

Fashion retailer New York and Company (NWY) also makes our list of small high quality cheap stocks. New York and Company has 512 stores in 43 states with 57 outlets and also sells though their web site. The holiday selling season looks to have been disappointing and the stock is flirting with 52-week lows.

The EV/EBITDA ratio is just 2.9 and they produced gross profits of $258 million with just $320 million of assets. So it fits our quality definition in spite of short term struggles. New York and Company has been around since 1918 and they have a solid balance sheet. As retail recovers, this stock has enormous upside.

Our final high quality cheap stock based on the acquirer's ratio is one I have owned for some time. Transworld Entertainment (TWMC) is cheap on any measure you might care to use. In addition to the EV/EBITDA ratio of 1.9 the stock is trading at 65% of book value and 80% of net current assets. The company is in the music and video stores business which is not exactly the world's greatest business these days.

Management paid out a special dividend last year and in the third quarter alone Company repurchased 158,794 shares of common stock at an average price of $3.63 per share so they are trying to build shareholder value.

Small-cap activist investor Lloyd Miller III has been a consistent buyer of the stock lately so he clearly sees a lot of value in the company. Miller currently owns 20% of the company. Transworld produced $138 million of gross profit on assets of $274 million and the market cap is just $106 million. This is one I consider too cheapo not to own at the current level.

Combining the small-cap quality measures with valuation measures does not produce a flood of ideas right now. But those that do show up have enormous long-term appreciation potential.

On Friday, we will wrap up the small-cap high quality overview with a look at those that trade at a discount to tangible book value -- my favorite measure of value.

Columnist Conversations

we like this chart here, it appears ready to move higher. BOUGHT BZUN OCT 35 CALL AT 3.40
Large-cap, high-quality McKesson (MCK) is too cheap now, at $147.51 or so. The stock hit $243.60 more than 2.5...
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