Three Tiny Treasures

In recent weeks, stock market investors have been living la vida volatile. The S&P 500 index plunged from a high of 1,225 to as low as 1,146 (a 6.5% decline) before staggering back up to close recently at just over 1,160 -- still a 5% loss. At Motley Fool Hidden Gems, our flagship publication for small-cap investors, we've felt the pain as well. Our portfolio, which in its inaugural year regularly posted gains in the range of 40% and more, has been hit hard. In fact, as of this writing, we're up "only" 28%.

But we're still beating the S&P 500 by a 5-1 margin. And those are just the results for our official recommendations. Our Watch List stocks -- the runners-up in our monthly stock-culling exercise -- are doing nearly as well. And our Tiny Gems -- high-quality companies in micro-cap packaging -- are beating the market by a 12-1 margin. (And, yeah, Tiny Gems' performance is more fluke than skill, but you know we're still grinning ear to ear reciting it.)

More than picks and statistics (enunciate it really well, and it rhymes)
What's more, we don't emulate the "pick 'em and forget 'em" approach of other investing newsletters. On the contrary, we've invested a lot of time and effort in finding these companies -- official recommendations, Watch List stocks and Tiny Gems all. And now that we've found them, we're not letting them out of our sight. Our team of Hidden Gems analysts continuously monitors these companies for news that our readers need to know and periodically updates them on developments in our companies, both on our Hidden Gems discussion boards, in monthly updates of the most interesting news, and in detailed semiannual reviews. And, of course, right here on Fool.com.

In today's news
Speaking of which, the past couple of weeks have been busy ones for our Gems. Earnings season is in full swing, and the business press is chock-full of profits news on our companies. Rest assured that we'll be covering the majority of the really interesting earnings announcements among the Gems and Watch List stocks either in separate articles or in expert-led discussions on our boards. Today, I want to update members on the latest news out of three of Hidden Gems' JV league: our Tiny Gems.

Image Sensing Systems (Nasdaq: ISNS  )
Like your car? Hate your commute? Then give a big "howdy" to Image Sensing Systems, because this traffic-camera designer aims to make traffic congestion a thing of the past. It's not a high-profile task. In fact, you've probably never heard of most companies working in this space, as they range from the small (Quixote (Nasdaq: QUIX  ) ) to the very small (Optelecom (Nasdaq: OPTC  ) ) to the very, very small (Image Sensing). But high-profile or not, Image Sensing is proving that by making traffic flow better, it can generate some cash flow as well.

On Thursday, this tiny company (and I mean tiny, with a staff of fewer than three dozen employees) reported $0.10 in earnings per diluted share, a 24% rise increase over Q1 2004. This despite a top-line increase of less than 3%. The reason for the huge jump in profits relative to revenues was that Image Sensing's lower-margin product sales declined by half year-on-year, while high-margin royalty revenue skyrocketed 39%. When most of your growth comes from sales that drop almost directly to the bottom line, as royalty revenues do, you can really supercharge your returns.

On the downside, it would be a mistake to assume that profits will continue to outperform revenue growth in future quarters. The company made a point of emphasizing both its backlog of equipment sales expected to take place in Europe and the fact that a new product is ready to begin selling in Asia. Both of those developments should lead to stronger revenue performance going forward, but with a consequent return of net margins to a more normalized level.

Lakeland Industries (Nasdaq: LAKE  )
It's a good thing Lakeland's specialty is manufacturing protective clothing. This sub-$100 million micro cap needs all the protection it can get as it does battle for market share every day against giants hundreds of times its size. Household names such as DuPont (NYSE: DD  ) and Kimberly-Clark (NYSE: KMB  ) compete against Lakeland. Worse, Lakeland also has to buy some of its raw materials from major competitor Dupont. As hazardous-to-your-business-health environments go, it doesn't get much tougher than that.

Lakeland operates on a somewhat different fiscal timeline from most other companies. So when it reported earnings on April 15, it was actually reporting for all of "fiscal 2005" just ended, rather than for a single quarter. For the year, Lakeland experienced a 38% rise in net profits on a 6% increase in revenue compared with fiscal 2004. Per-share profits didn't do so well, however. The company issued 1.3 million new shares back in July 2004, diluting the extra net profits by 40% and reining in per-share profits growth to just 11%.

Worse, from Wall Street's perspective, the company isn't expecting to see per-share earnings rise at all in fiscal 2006, because of a combination of increased costs for Sarbanes-Oxley compliance, rising raw material costs, and additional stock dilution from a planned stock dividend that will be declared at the end of this week.

One final issue to keep an eye on with this company is the rate of inventory growth vs. sales growth. Despite revenues rising just 6% last year, inventories grew nearly 18% -- three times as fast. As is often the case with companies where inventory growth outpaces sales growth, the buildup in inventories also took a toll on the company's cash flows. After generating positive cash flow for two years running, Lakeland turned free cash flow negative in fiscal 2005 for the first time since 2002.

Preformed Line Products (Nasdaq: PLPC  )
Batting cleanup for this line of happy-news bearers comes wire and cable encloser Preformed Line Products. And this slugger packs a wallop, as demonstrated by its first-quarter 2005 results released Monday. Compared with the year-ago quarter, Preformed Line ramped its sales up 28% and extracted from those results a 143% increase in per-share diluted profits.

That's outstanding. And what's more, the company's accounts receivable increased just 7% against the 28% sales increase, and inventories actually declined year-on-year. The way I read that, we're looking at a company with real sales here (channel stuffers need not apply) -- a company whose products are in such demand that it's able to require prompt payment from customers, while selling off goods almost as fast as it can manufacture them.

Combine strong profits with a strong business, and then throw in shareholder-friendly management that doesn't dilute outside shareholders but rather pays them an above-market-average 2.4% dividend. Small size or not, this one could be a true gem of an investment.

The first team
That's all the news on these JV Gem candidates for this week. Covering all three in a single column, I've necessarily abbreviated each write-up to fit the space allowed. But if you find yourself intrigued and wanting to learn more about these three Tiny Gems, you're welcome to peruse the Hidden Gems site free of charge for a month by clicking here.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. The Fool's disclosure policy may be tiny, but it's got a big heart.


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