3 Small-Caps Show Quality Comes in All Sizes

 | Sep 21, 2015 | 4:00 PM EDT
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It was a very busy weekend around Chez Melvin. We had company in from out of town, the neighbors had a party and, of course, there was almost nonstop football and pennant-race baseball.

In the middle of all this, a good friend sent me a recent study from Cliff Asness and his team of incredibly smart people at AQR Capital. The study, hilariously titled "Size Matters, if You Control Your Junk," is one the more interesting and potentially profitable works I have read in recent months.

The size premium is often dismissed as being a weak anomaly, produced primarily as a function of tax selling and nano-cap stocks. However, Asness and company found that if you eliminate all the "junky" small stocks the size effect is very real and very profitable. Specifically, they found that focusing on those small-cap names with high levels of profitability, profit growth, safety and payouts, crushes the overall stock market.

I ran a few simple tests using measures that I believe identify these factors and limited my results to just those companies below $200 million in total market capitalization. The resulting list offers some incredible candidates for long-term investment and lends some weight to Warren Buffett's comments a few years ago that he would be earning 50% a year if he was managing smaller amounts of money.

Simply put, there are some companies here with the potential for extremely high long-term rates of return.

Based in South Africa, MiX Telematics (MIXT) provides fleet and mobile asset management solutions. Its software allows companies to collect, analyze, and deliver data from customers' vehicles and even record and review driver behavior while in company vehicles. MiX works with a wide range of companies, including those in the oil and gas, transportation and logistics, government and municipal, bus and coach, and rental and leasing industries.

MiX is growing, pays a dividend and has an Altman Z-score of 5.88. Using the Novy-Marx gross profitability measure, MiX has gross profits that are 41% of total assets, easily passing the quality definition. Book value has grown 21% annually over the past five years, so the company also passes my growth hurdle. What's more, the company is actively buying back stock and there has been recent insider buying so management apparently believes the shares are a bargain at current levels.

ClearOne (CLRO) designs, develops and sells conferencing, collaboration, streaming and digital signage solutions for voice and visual communications. The Utah-based company's products are used primarily for audio, video and Web-conferencing applications. It also makes signage products that deliver digital content and information to digital displays, televisions and room signs.

The company's book value has been growing at about 50% annually for the past five years and it reported record earnings in the second quarter. Gross profits are 41% of total assets, so it passes profitability measures. ClearOne's Z-score of 7.50 tells us it is financially sound. The dividend yield is currently 1.2%, so there is a shareholder payout, too

Liberator Medical Holdings (LBMH) will be familiar to anyone who watches the cable TV channels and sports networks. Its commercials are a staple with actors and actresses pushing their lines of catheter supplies, ostomy supplies, diabetes supplies and mastectomy fashions for home delivery. This is the quintessential small-cap quality stock.

Liberator's book value growth has averaged 32% annually and its gross profits are 32% of total assets. The company's balance sheet is solid with a Z-score of 5.86 and the shares are yielding 5% at the current price.

According to a recent company presentation, Liberator's marketing yields a revenue return on ad spending of approximately 6x and recurring sales from customers of 85%-plus. I like just about everything about Liberator and apparently so does Mario Gabelli as his funds increased their position ten-fold in the most recent quarter.

I would have to find something horrific in the 10Q and 10K filings to keep me from buying this stock soon.

I highly suggest that you spend the time to run some screens and do some digging for high-quality small-cap stocks. There are some very interesting small companies that are safe, pay dividends and growing at a healthy pace. Most are too small to write about here but these three stand out as examples of the type of companies that the study by AQR Capital suggests can deliver market-beating returns over time.

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