10 Small Caps to Rule Them All

Small-cap companies are absolutely one of my favorite areas to research because you can often uncover hidden gems that analysts have neglected or simply not discovered yet. They can offer the ultimate risk-vs.-reward ratio, but they are not for the faint of heart.

This 10-week series is dedicated to finding the 10 small caps to rule them all. Here are the previous six choices:

• Golden Star Resources
• Buffalo Wild Wings
• Integrated Silicon Solution
• True Religion Apparel
• Allegiant Travel
• Aeterna Zentaris

This week I want to highlight Chinese solar cell manufacturer JA Solar (Nasdaq: JASO).

What it does
JA Solar, as its name implies, develops and manufactures photovoltaic solar cells in China. In English, this means the company produces panels which transform sunlight into usable electricity for businesses. Revenue increased by 211% last year to $1.78 billion from $572.5 million in 2009 while annual gross margins rose from 12.8% to 21.7%.

How it stacks up
Two things are vital to the success of solar-based companies: keeping costs under control and consistently bringing in new contracts. For JA Solar, worrying about new business is not in its game plan. The company has roughly 90% of its production for 2011 under contract already, leaving little worry about future cash flow.

Sources: Yahoo! Finance and company filings.

Despite what looks like a very inexpensive sector, speculation of an eventual slowdown in orders has been factored into prices, keeping this sector at very low P/E multiples.

You’ll notice that solar companies with higher costs per watt trade at considerably lower multiples than First Solar, which by all standards here is aggressively priced. JA Solar has one of the lowest cost per watt averages of the bunch and the second lowest forward P/E ratio, trailing only LDK Solar. The reason LDK isn’t the go-to choice relates back to contract worries. LDK doesn’t have nearly as many orders lined up for 2011 as JA Solar and would suffer considerably if demand dried up -- as would rival Canadian Solar. Based on the above information, JA Solar seems reasonably undervalued compared to its peers. Now let’s see if that could translate into making you money.

How it could make you money
First and foremost there’s something to be said about the security of free cash flow. Because JA Solar has approximately 90% of its production contracted out, you can buy into the company with the confidence that a demand slowdown won’t affect you much. It’s true this is a double-edged sword -- JA Solar’s margins will suffer if solar cell prices rise, given that its production contracts can’t be modified -- but the prospect of guaranteed cash flow is too enticing to pass up, especially in turbulent markets.

The debate over the safety of nuclear energy following the tragedy in Japan has stirred the pot as to whether solar-based energy generation should be expanded. JA Solar and its proximity to Japan could play a large role in the company obtaining a considerable boost in business from the rebuilding process.

Finally, the company metrics say it all. JA Solar already boasts one of the lowest cost per watt ratios and is trading below five times forward earnings. After producing nearly $194 million in operating cash flow last year and increasing shareholder equity by 38.5%, I see no reason why this solar cell manufacturer doesn’t deserve a spot in the 10 small caps to rule them all.

What’s your take on JA Solar? Share your opinion in the comments section below and consider adding JA Solar as well as your own personalized list of stocks to MyWatchlist.

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