A Peter-Lynch-Style Small-Cap

 | May 16, 2012 | 3:30 PM EDT
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Peter Lynch, one of the greatest money managers of all time, recounts some of his best investment ideas in his classic book "Beating the Street."

He tells a story of how on business trips, he would stay at the La Quinta Inn. He was so impressed with quality of the rooms for the price he paid that he ultimately invested in the company. He tells a story of how his wife came to tell him about the popular Hane's pantyhose that were sold in the egg shells at retail and grocery checkout line. He checked out Hane's, liked it and invested in it. He did the same thing with Taco Bell and Pep Boys (PBY). All of those investments turned into huge winners.

The commonality among these Lynch multi-baggers? First, Lynch did his own scuttlebutt analysis. He saw what each business had to offer and liked it. Second, these businesses were, at the time, smaller businesses with healthy balance sheets and great growth potential. In the words of Lynch, "(b)ig companies don't have big stock moves ... you'll get your biggest moves in smaller companies."

Department store Stein Mart (SMRT) today looks like a perfect Peter Lynch small-cap play that offers various ways to reward patient investors. The company has a market cap of $270 million, no debt and more than $90 million in cash. Based on the current $6.35 share price, the cash comes out to more than $2 a share in cash. On top of an excellent balance sheet, SMRT is a cash cow. Over the past three years, free cash flow has totaled nearly $140 million. While the company has no regular dividend policy, it paid it more than $20 million via a special dividend in 2010, or $0.50 a share in 2010. With so much cash on the balance sheet, I wouldn't count out future special payouts.

I paid a visit to a Stein Mart recently to pick up some socks and I came out with not only socks, but very impressed with what I saw. This wasn't my first time in Stein Mart, of course, but it was my first time really opening my eyes and looking at what the company is all about. I found a pair of pajama pants for $10 that I would cost $40 at Bloomingdale's,dress shirts for $40 that would cost $100 at Nordstrom and other brand names that I was surprised to find.

This merchandising is no accident. Over the past few years, SMRT had added over 150 designer brands and those brands now count for 61% of sales ves. 33% of sales in 2009. These brands include names like Vineyard Vines, Michael Kors, Elie Tahari, and Tommy Bahama. In adding to upscaling the merchandise, SMRT is remodeling stores and expanding its e-commerce sales channel. The company's 264 stores are located in strong, powerful shopping centers close to upscale residential areas. The company has reduced costs by more than $100 million in the past three years.

Stein Mart is a department store offering better prices. I surmise that over the next five years the company will generate more cash flow than its current market cap today. One of the best ways to value a business is to ascertain its value to a private buyer. The current market value is significantly below that private value. When you strip out the cash, the current value of SMRT is $180 million for a business that will probably return that cash to you in 3-4 years time via free cash flow.

The company reports its earnings tomorrow. I would look at any news that sends shares lower as a golden opportunity to buy shares.

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