Great Stocks Under Rocks

We write here frequently about the rewards of investing in small, quiet, possibly boring companies that are not on the radar screens of big money or big media. This past spring, I had an opportunity to interview Peter Ricchiuti, a one-time Wall Streeter and now a professor at Tulane University in New Orleans, about this topic -- one that's near and dear to his heart.

Ricchiuti has set up a program at Tulane that has his graduate and undergraduate students visiting and researching small local companies and then writing in-depth reports on their research. Their reports, which I recommend you read, are available at the Burkenroad website.

Because of Katrina, the program operated on a truncated basis last year and not all of the reports are full length. But the students still managed to cover a number of companies, and they put on an excellent investment conference in May that was open to the public.

Peter calls his program "Stocks Under Rocks." In keeping with such a motto, Burkenroad typically covers companies with mundane investment opportunities such as ice, eggs, termite extermination, pool-cleaning supplies, frozen-food trucking, and cement. How have those companies done in the eight years that Peter and his crew have been following them?

He responds:

I think they have done really quite well, right from the onset. The numbers I have go back about eight years, and in the last eight years, the average stock we have followed has outperformed both the S&P 500 and the Russell 2000 [the small-cap index] in each of those years.

I guess the better gauge might be that about four-and-a-half years ago, one of the local banks created the Burkenroad Mutual Fund, which trades under the ticker symbol HYBUX. It's mainly made up of the stocks that we follow, and they utilize our research. They actually manage themselves. We are not registered investment advisors, but that fund has been open four-and-a-quarter years and is up about 106% and has outperformed 97% of the nation's mutual funds.

Part of the explanation for the dramatic outperformance is the simple excellence of small-cap returns over the past eight years. Another part is the concentration in energy stocks, which makes sense given Tulane's proximity to so many energy companies.

Here's the formula that Ricchiuti gives in looking for companies to follow in his program:

  1. Market caps of less than $500 million.
  2. Usually just a handful of analysts following the company, or perhaps none at all.
  3. Companies that are easily understood. Ricchiuti says he wants to be able to "understand the drivers" of a company. Not being able to do that "has really kind of kept us away from tech ever since the beginning, where we just didn't know if we could really get our arms around companies in such a way," he said.
  4. Companies that have significant management ownership. "A lot of analysts view that as a real negative because it takes shares away from the float and it makes a little bit more illiquid, and that is true," Ricchuti said. "But we think that is overweighed by the fact that these managements are really in the same boat as you, the investor. They wake up every day trying to get that stock price up, and the bulk of their wealth is in the same company."

There are a number of interesting ideas for small-cap investors that come out of the full interview, which you can access by taking a free trial to Motley Fool Hidden Gems. Here are a couple of ideas and companies discussed in the interview.

First, there's a company that Burkenroad Reports began following about six years ago -- Hibbett Sporting Goods (Nasdaq: HIBB  ) , based in Birmingham, Ala. Management in particular has impressed Ricchiuti with its vision and execution, and when the story is explained, it is really a pretty simple one. Ricchiuti recounts:

This was a company that now has about 700 sporting-goods stores all throughout the Southeast, with the most amazing model that sounds very, very simple. But when they laid it out to us, you could tell it was going to work. They basically were going to put stores right next to every Wal-Mart (NYSE: WMT  ) Supercenter that was open in a small community, and they basically get the overflow.

They pay very little for advertising. The stores are only 5,000 square feet instead of 50,000 square feet for an academy or some big operation like that, and the stores paid for themselves very, very quickly. That model just made sense.

Oddly enough, the stock of Hibbett during that time is up about three- or fourfold, and the stock of Wal-Mart hasn't done . much of anything. So it is kind of interesting to see who the real beneficiaries of the growth were.

Small-cap winners
What are the keys to finding winning investments in the small-cap world? Ricchiuti explains:

I think it is very much swimming against the stream, looking at companies that on the surface look very, very boring, and being able to go through and crunch the numbers and really look at the business drivers in there. In other words, we have done a lot better in finding companies that have decent margins [and] attractive business models but not . margins that are so large that they are starting to attract a lot of competition . companies where there is a little bit of a moat . where it is difficult to compete against them. That is what I think is out there, and I still think they will always be out there.

One of the difficult things is, it is going to take looking through the Internet. It is going to take digging around on a lot of sources. Because if you look at traditional Wall Street research, it is probably not going to help you uncover these companies. As good as it is, and I certainly have a lot of friends and former students in that business, I have found very few great opportunities by reading research that is coming out of Wall Street. It is really digging around on your own.

I asked Ricchuti: How does a small-cap company get a moat? His reply:

There is some sort of barrier to entry. A good example would be that we follow a company that has actually grown quite a bit since we began following it -- a company called Lamar Advertising (Nasdaq: LAMR  ) , which is the third-largest owner of billboards in the United States. [This] is an industry where [you can't] put billboards just anywhere. If you have a billboard, if you have that site, you basically have it for life, and you really do have a built-up advantage. . And then when you are of a certain size, you can buy out the smaller competitors, and things like that. That is what we are looking at.

Then sometimes you will find situations, for instance, like the Hibbett story we just talked about, where you look at Hibbett and you think, "Boy, maybe Wal-Mart could beef up their sporting-goods department and try to compete with Hibbett that is right across the parking lot." But that is not going to happen. Now, Wal-Mart has a certain model that they are working on and [a] certain price range of their products, and they are not going to turn around just to try to get some market share off of Hibbett.

That is what you want to look for -- just some way where [advantages] are built into the program a little bit. You can feel good not only about this year's earnings but have some visibility going forward. That is the other thing the students look at, and when we assign a P/E ratio or a target P/E, one of the things we will pay up for is earnings visibility.

It sounds like a very unsexy business, but Ted Turner's money came from there, [as did the money of] the Rollins family; Wayne Huizenga, the guy that owned the Florida Marlins; the new guy that just bought the Anaheim Angels -- this all came from the billboard industry. One of the things that we have found recently is that the billboard industry is going to be a big beneficiary of [commercial-free] satellite radio, and that is because XM (Nasdaq: XMSR  ) and Sirius (Nasdaq: SIRI  ) -- people want to own those stocks, but they look terribly overpriced on our matrix.

But if you look at it, one of the big beneficiaries will be billboards, because the thing about satellite radio is that it doesn't allow advertisers. And advertisers are realizing that the only way they can get into someone's car once they have satellite radio is through the billboard. And you are looking at 7 million subscribers and a very, very hefty growth rate in that. I think eventually that is going to translate into higher rates for those billboards.

Getting one up on the market
Why does Ricchiuti think small caps are the way to beat the market?

I have nothing against people that follow Microsoft (Nasdaq: MSFT  ) , for instance, but if you are the 61st analyst to be writing a report on Microsoft, the odds of you kind of coming across a new way to look at it or a new piece of information just seems very, very remote. Even though the valuations are up versus the large caps, I still think that the bulk of the opportunity is in these -- when you get past the S&P 500 and you start going south on valuations. I think that is really the only place.

The bottom line is that in academia, in finance, you always hear talk about the efficient-market hypothesis and such. What I think is starting to come to fruition here is the idea that the top of the market is very, very efficient.

But when you start to go to the smaller companies, that is where the inefficiencies are, and that is where I think investors need to be playing. I know this in the context of asset allocation, but the small-cap area really does shine above the others for opportunity, even though the overall valuations have come a lot closer together.

This year, with an uninterrupted school year at Tulane, the Burkenroad program should be back to producing full-length reports on all 40 or so of the companies covered. As I mentioned before, the spring conference is well worth attending for individual investors, all of whom are welcome. That's not typical for an investment conference.

In the meantime, if you're looking for more small-cap coverage, you can take a free 30-day trial of Motley Fool Hidden Gems, which covers a number of the companies covered by Burkenroad. Like the Tulane program, these companies have succeeded in outperforming the market. We agree with the good professor that small caps are the place to look for the best market-beating opportunities.

For related coverage:

Bill Barker does not own shares in any of the companies mentioned in this article. Microsoft and Wal-Mart are Motley Fool Inside Value recommendations. XM is a Motley Fool Rule Breakers pick. The Fool has a disclosure policy.


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