Some of my favorite businesses to find and follow are small caps -- businesses valued by the market at roughly between $200 million and $2 billion -- that typically aren't on the radar of very many analysts or investors. These smaller businesses are certainly volatile, but amid the short-term volatility, gems can exist for patient investors. Here are three small caps that recently found their way onto my watchlist and that I think you will also want to keep on your radar.
1. The Chefs' Warehouse
The Chefs' Warehouse (NASDAQ: CHEF ) distributes gourmet and high-grade specialty food products to more than 20,000 locations in the U.S. and Canada. Through its sales force of approximately 300 professionals (many of whom have culinary degrees and backgrounds) in 14 geographic markets, Chefs' Warehouse focuses on meeting the specific needs of chefs who own and/or operate venues such as independent restaurants, country clubs, fine-dining establishments, hotels, caterers, cruise lines, casinos, and other specialty-dining establishments.
Chefs' Warehouse's product portfolio of 30,000 stock-keeping units, or SKUs, is composed of gourmet foods and ingredients that are classified as gourmet because of their uniqueness, exotic origin, or particular processing method used. More than 1,600 different suppliers from North America, Asia, and Europe supply these ingredients, which gives Chefs' Warehouse an edge. For instance, most broadline food distributors (such as Sysco) carry five to 10 types of olive oil, while Chefs' Warehouse provides a selection of more than 160 olive oil varieties.
Going forward, Chefs' Warehouse sees the potential for increased sales from current customers and an expanded customer base within its existing markets. In 2013 alone, the company entered six new markets. Over the past four years Chefs' has implemented an internally developed Web-based platform that provides real-time sales, pricing, and profitability analysis to its management and sales professionals, which should help scale the business in the years ahead. The company has also made five acquisitions that totaled $152 million since 2012 to expand its market penetration and product categories (including the direct-to-consumer market).
Chefs' was co-founded by two brothers -- Christopher and John Pappas -- who together own more than 21% of its shares outstanding. This high level of insider ownership, combined with a niche business and recent expansion, is a good reason to put Chefs' Warehouse on your watchlist today.
2. Paycom Software
Paycom Software (NYSE: PAYC ) provides a cloud-based platform for employers to manage employees in areas such as payroll and HR. Paycom developed its human capital management, or HCM, platform in-house to manage "the entire employment lifecycle" from recruitment to retirement. The platform does not need to access or integrate with multiple databases and it also collects data (in a single database) that employers can access and analyze in real time.
Paycom provides personalized service to its 10,000-plus clients, as it assigns a trained specialist to work with each client. Paycom has clients in all 50 states, and the company itself has 30 sales teams in 20 states. Management believes the company can expand in existing markets while adding up to 100 sales teams in the coming years. Paycom plans on opening six to eight new sales offices over the next two years. The company has an average annual revenue retention rate of 91% for existing clients for the three years ended Dec. 31, 2013.
Paycom's revenue grew from $57.2 million in 2011 to $107.6 million in 2013, with net income increasing from $1.4 million to $7.7 million over the same period. Founder and CEO Chad Richison owns 11% of the shares outstanding.
3. Inventure Group
Inventure Group (NASDAQ: SNAK ) manufactures and markets a variety of specialty snack foods -- including healthy/all-natural snacks and "indulgent" snacks -- in the frozen food and snack food segments. This includes a diverse line of snack products, frozen berry products, frozen vegetable products, and smoothie kits through its own brands as well as through licensing agreements.
I see these licensing agreements as the greatest competitive advantage of Inventure Group in what is otherwise a very competitive industry that includes larger players such as PepsiCo and ConAgra. While Inventure Group is also engaging in some acquisitions in addition to expanding its own line of products, take a look at these licensing agreements with bigger names for yourself:
- In 2000 Inventure Group entered a license agreement with T.G.I. Fridays, which expired in May 2014 but was extended to 2024. In 2013, 18% of Inventure Group's revenue came from T.G.I. Friday products (down from 28% in 2011).
- It entered a license agreement with Jamba Juice in 2009, which is good through 2035.
- In 2011, it entered a license agreement with Nathan's Famous, which expires in 2031.
- In 2012, it entered into a license agreement with Vidalia Brands, which expires in 2019.
- In November 2012, it entered into a license agreement with Seattle's Best Coffee of Starbucks, which is good through November 2017, and which will automatically extend for another five years if minimum sales targets are met.
These licensing agreements with bigger players in the snack food industry are reason enough for me to keep Inventure Group on my watchlist. What is key is whether Inventure Group is building enough of a sustainable competitive advantage to flourish in a very competitive field and deliver market-beating returns to investors in the coming years.
Foolish bottom line
Small businesses are often volatile in the stock market and investors should only buy them after careful consideration. Rather than getting emotionally tied to short-term market movements, however, patient investors who are focused on following the underlying strengths of a business have a good chance of outperforming the market over the long haul.
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