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Considering the enormous potential that exists in the small-cap sector, from time to time my staff and I like to take a closer look at some of the market's lesser-known firms. Although they might not appear in the headlines or receive much coverage on Wall Street, many of these smallcap companies are going to deliver incredible returns for their early shareholders. For a variety of reasons, every investor's portfolio should probably contain at least a handful of smallcap stocks. For example, studies have shown that on average, smallcap stocks have historically outperformed largecaps by almost +3% per year. While this may not seem like a great difference, keep in mind that over the course of 25 years an extra +3% annual return can mean the difference between a $500,000 portfolio and a $1 million portfolio. For an added kick, it is worth noting that smallcap value stocks (those that trade at low P/E and low price-to-book ratios) have historically delivered even greater returns than their growth-oriented cousins. Since smallcap firms are usually not very diversified, they generally do not weather economic downturns well. However, when the economy turns the corner, they tend to outperform. A look back at prior economic recoveries shows that smallcap companies do exceptionally well when times are good. There are a variety of reasons for this. For starters, because they tend to be smaller and more nimble than their larger competitors, smallcap firms often beat their larger rivals to market and seize new opportunities. In addition, since their revenue and earnings streams tend to be relatively small, even a slight pickup in business conditions can easily lead to 20%, 30%, even 50+% annual growth for smallcap companies. By contrast, when it comes to largecap companies like, say, General Electric (GE) or Wal-Mart (WMT), both of which are already earning billions of dollars, improving business conditions are unlikely to have such a dramatic impact on their bottom lines. Finally, since you should still take a value-oriented approach when examining smallcaps, if the firm you're analyzing has EPS growth estimates available, then it is important to look at the company's PEG ratio. You can easily calculate this ratio by taking the stock's P/E and dividing that figure by the company's expected annual earnings growth rate. As a general rule of thumb, you'll want to look for companies with PEG ratios of 1.5 or less, as these tend to be reasonably valued relative to the firm's underlying growth potential. With all of these factors in mind, in today's issue we're pleased to introduce you to five promising smallcap companies that could handily outperform the broader market in the months and years ahead... DRUGSTORE.COM (DSCM, $5.88) The company’s financial statements support the bullish turnaround story here. At one time during the dot-com boom the stock reached a peak near $70. Since then, however, the shares have fallen precipitously, as Wall Street has given up on the firm. In fact, at its all-time low the stock fell below 50 cents per share. Yet despite the market's unwillingness to be patient with this long-term winner, the company has continued to build its brand and execute its business model to perfection. We believe Drugstore.com has already weathered the worst of the downturn and has emerged as a true survivor. Sales are rapidly increasing and the firm's business is finally be gaining momentum. The company also boasts $40 million in cash and just $1.4 million in debt on the balance sheet. In addition, Drugstore.com's marketing cost per customer has fallen dramatically in recent years, reaching a recent low near $17. This should provide the firm with an opportunity to make a real marketing blitz in the future. Profit margins are on the rise as well, exceeding 22% in recent quarters. We like what Drugstore.com has to offer and we're encouraged by the firm's prospects. The company has smartly acquired weaker rivals on the cheap in recent years, helping it become the Internet's premier wellness products retailer. Drugstore.com also continues to branch out into new areas. For example, the firm recently established a new online shop that features organic guru Dr. Weill. This should help build sales with minimal cost. Judging by the recent success of both Amazon.com (AMZN) and Overstock.com (OSTK), it's clear that online retailing can be highly profitable. We believe Drugstore.com will emerge as not only a survivor, but also one of the leaders in this growing industry. As sales and margins both increase, the firm's bottom line is poised to grow at an exponential rate. Shareholders should benefit in the future as this emerging Internet leader continues to grow.
DYNATRONICS (DYNT, $2.35) Dynatronics is involved in three main business lines: chronic pain, rehabilitation, and aesthetic. More specifically, the company manufactures and distributes products such as medical supplies, therapy devices, rehab equipment and skin care items to physical therapists, dermatologists, sports medicine practitioners and surgeons across the country. Although the company has an established track record in many markets, the real potential for this virtually unknown microcap gem lies in a new product it has developed. Going forward, the firm could see a real boost in earnings if it experiences success with "Solaris" -- a new type of therapy for muscle, back and arthritis pain that uses light rather than ultrasound. On a more general note, the aging U.S. population also plays right into Dynatronics' favor. Assuming that the firm can successfully sell its line of therapy products to aging baby boomers, we see a big future in all three of Dynatronics' business lines. And on the valuation front, the company trades at roughly 1x last year's revenues, which is about as cheap as any stock gets. In terms of growth, the firm posted a strong jump in earnings last quarter on a +20% increase in sales. With all of these factors in mind, DYNT is worth a closer look for those investors willing to venture into the microcap arena. SAVVIS COMMUNICATIONS (SVVS, $2.34) Looking back to the Internet boom years, C&W spent over $2 billion to build out its network before abandoning its U.S. operations late in 2003. With this purchase, Savvis bought not only the firm's network assets, but also gained access to 3,000 existing customers that generate roughly $450 million in sales a year. These new customers will almost triple the firm's existing revenue base and will vault Savvis into the ranks of one of the nation's top network and hosting providers. The main downside to this acquisition is the increased leverage the firm had to take on in order to complete the deal. The financing structure is very complex, but the company basically took on $200 million in debt at interest rates of up to 15% in order to pay for the transaction. This makes the stock a much riskier play than it was previously. On the operational side, Savvis managed impressive operating margins of 25% prior to the deal, and we believe that through cost cutting and synergies this will only improve. Given that the market is still trying to digest the terms of this deal, the stock has been extremely volatile as of late. We're going to keep our eyes on this company, but will likely wait until the firm begins to integrate the purchase and the stock stabilizes before making a final decision on the shares. In the long run, the deal could be very successful and could ultimately reward shareholders. Between now and then, however, Savvis will undoubtedly go through a very bumpy transition period. MULTIMEDIA GAMES (MGAM, $21.00) The company currently has over 10,000 machines linked across the nation on its proprietary network, Betnet, which enables players to simultaneously play lotto, bingo or other games for a chance to win pooled prizes. As more and more states grant rights for tribes to operate gaming parlors, the gaming equipment market should continue to expand in the years ahead. As an industry leader, MGAM stands to profit tremendously from this trend. In addition, the company should see strong sales to existing casinos that are looking to replace aging equipment. The company's figures show that customers generate up to 300% more profit per seat for the operator when playing on MGAM's systems. Talk about a great sales pitch. Multimedia Games is in very solid financial shape as well. Management has been very resourceful in managing its capital, delivering a solid 34% ROE (return on equity) in recent quarters. On the valuation front, the stock sports an extremely low PEG ratio of just 0.69. The shares also trade at a conservative 1.4X sales. With just $15 million in long-term debt, projected earnings of $3.21 per share next year and expected annual growth of +20% going forward, the company appears to be in excellent shape. Similar to what we've seen with many other gambling-related stocks, the major overhang on the company continues to be legal issues. For years people have been concerned that the market for gambling products will dry up as regulators and politicians tighten the reigns on gambling. This scenario has not played out in the past, and we do not see any reason why this will change in the future. The bottom line is that this industry generates sorely needed revenue for state governments, so we think it's only going to get bigger in the years ahead. Multimedia has been very successful in negotiating with state authorities and Indian tribes to secure favorable terms for both parties. As one of the fastest-growing players in this industry, MGAM is worth a closer look. The stock might make an excellent addition to our "Aggressive Growth" Portfolio, so be on the lookout for a possible news flash on this company in the coming weeks. SAUCONY (SCNYB, $23.90) That's not to say that Saucony is a struggling newcomer in this industry. Far from it. In fact, the company is very well established, having been in business for over 100 years. Although the firm's management tends to be very conservative, we think Saucony has the potential to grow at a very nice 15+% clip in the coming years. Why? For the answer to that question, just look around at what young people are wearing nowadays. Retro is in style, and Saucony has a great line of retro-style shoes that are catching on with a younger generation. Saucony has been making a comeback against its larger rivals as people try to differentiate themselves from the masses. You probably will not see a pair of Saucony shoes on your local basketball court, but you more than likely will see them trotting around college campuses. This new trend bodes well for Saucony, and we believe the company is poised to gain market share and increase sales at a steady clip in the upcoming years. Trading at around 1X sales, Saucony's shares are very
reasonably valued at the moment. The company also recently announced a
special one-time dividend of $4 per share. The most recent data we have
indicates that this special dividend is payable on March 17th to all
shareholders on record as of March 3rd (the exact dates and timing of
these special dividends are sometimes subject to change). Please note
that the stock will drop roughly $4 on the ex-dividend date. However,
holders of SCNYB at that time will receive $4 in cash later in the
month, so their true cost basis for the shares will drop by that amount.
After that takes place, we expect the shares to rally back above current
levels (at least into the mid-$20s) by the end of the year. We added
this stock to our Value Portfolio via a special news flash in intraday
trading the afternoon of Tuesday, February 24th, and have initiated
coverage of the firm with a "Buy" rating and a 12-month price
target of $25.
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