Roundtable: Will CIT Smack Small Caps?

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The Motley Fool Hidden Gems team spends a lot of time talking stocks. Seriously. You do not want to hang out with us at a bar, unless you get a thrill out of listening to smack-talk about how to calculate return on invested capital, or who's most likely to feel the pain when a lender you've never heard of goes belly up in the Wall Street pool. This week, I asked the team to reflect on the latest economic news, viewed through the lens of the small-cap investor. Here are their responses (as well as my own).

Question: JPMorgan Chase (NYSE: JPM  ) and Goldman Sachs (NYSE: GS  ) report record numbers, but consumer spending is still in the dumps. GM is out of bankruptcy thanks to a taxpayer bailout, and an expensive-looking health-care reform bill of some kind is on the docket for the coming month. Does this week's financial news change your opinion on small caps in any meaningful way, and what's one non-Hidden Gems small cap that you're interested in these days (for good or ill)?

Andy Cross, Co-Advisor:
How about the news that the Feds aren't going to toss a lifeline to CIT Group (NYSE: CIT  ) , a primary lender to small businesses? This means there could be thousands of CIT clients who have to seek funding elsewhere when credit's not exactly flowing. And that could have a short-term impact on small business employment.

Regardless of CIT, Goldman, or GM, my outlook for small-cap stocks continues to look bullish as we climb out of this bear market. But we have to be diligent and selective in our process, looking for companies that are built to thrive through a year or two of challenges. Cubic (NYSE: CUB  ) looks interesting because it's involved in two businesses that have staying power: defense electronics and transportation fare collection systems (like the smart cards we use here in D.C.). Unfortunately the stock is trading near its 52-week high, so I'm looking for a pullback before I dig deeper.

Nate Weisshaar, Senior Analyst:
Since I find little in this week's news to change my overall view of the economy in any way, it also doesn't change my view of small caps. To elaborate, I have yet to see anything that makes me believe the U.S. or global economy is going to stir to life any time soon. Small caps generally lead the pack when we have shifts in economic activity, up or down. However, since I don't expect to see much broad recovery any time soon, I'm looking for companies addressing the few areas that should see growth while the world languishes.

In this vein, I like the recently Nasdaq-approved RINO International (Nasdaq: RINO  ) , a company tied into pollution control at iron and steel plants in China. The company is just starting to achieve positive free cash flow, but the growth potential is astounding, even in this economy.

Seth Jayson, Motley Fool Hidden Gems Co-Advisor:
To me, the most interesting (or is it teeth chattering?) economic news lately is the continued sluggishness of consumer spending. Consumer spending represents more than two thirds of our economic activity, and without it, economic growth, as well as corporate profits, will be hard to come by. Manufacturers aren't going to begin reinvesting until they have some faith that the capital purchases they make will be utilized and generate a reasonable return. That can make it especially tough on smaller companies, and it's caused some bumps in the recovery (or is that runup?) in some of our Hidden Gems real-money holdings such as Dynamic Materials (Nasdaq: BOOM  ) .

Restaurants were hot a month or so ago, but then they lost their …  sizzle. (I know. Booo!) This week's news from YUM! Brands (NYSE: YUM  ) may cool them off even more. While longtime Hidden Gem Buffalo Wild Wings (Nasdaq: BWLD  ) tends to be a Fool favorite, I'm also watching Sonic (Nasdaq: SONC  ) , which runs a popular drive-through chain. Cash flow production looks healthy, but it carries a hefty slug of debt. Its returns on invested capital looks pretty impressive, however, so if it can manage the debt load and soggy sales, it could be a big winner when the growth ramps up again.

Mike Olsen, Senior Analyst
The market would have you think the economy is all smiles and sunshine, but I'm not sure that good results from JPMorgan or Goldman mean much. JP results were driven, primarily, by brokering debt and equity offerings for hard-up companies. Goldman's came from record trading revenues. None of this will prompt any miraculous change in consumer sentiment. Loan losses have hardly leveled off, and a newly deleveraged (or deleveraging) consumer might be a little less willing to spend. Sure, it's getting better. And stocks are still really cheap. But whether the storm's passed, that's anyone's guess.

Today, I like natural gas. The market's lost its mind over ballooning supply and declining industrial consumption, driving natural gas prices into the gutter. In turn, natural gas is selling well below the cost of production. Producers are scrambling to take capacity offline, and rig counts are more than 50% below year-ago figures. So unless the cost-curve's in the midst of a radical re-adjustment, or we've reconsidered our consumption of natural gas … a recovery's in the offing, somewhere, sometime. My poison of choice: Ultra Petroleum (NYSE: UPL  ) , which actually produces a lot of natural gas. Reasonably leveraged, great management, and a very low cost of production.

Keith Beverly, Senior Analyst
The mixed news we are hearing this week doesn't materially change my view on small caps, or any other caps for that matter. As we continue to digest economic news we have to remember that it took years for consumers to become leveraged to the hilt, and it likely will take years for them to dig out from under all that debt. Now, after that bah humbug, struggling consumer talk, what non-HG small cap most interests me?

You guessed it. (Or maybe you didn't. What am I, a mind reader?) It's Netflix (Nasdaq: NFLX  ) -- a consumer discretionary company from the sector I just trashed. To the extent a company like Netflix, with years of outsized growth in front of it, is dragged down by generally negative consumer sentiment, there may be opportunities to snatch up a growth story on the cheap. In the interest of full disclosure, I became a Netflix subscriber last week -- coincidentally (or not) the same week I ordered my first BlackBerry courtesy of Research In Motion. I've officially joined the 21st century. 

Stan Huber, Senior Analyst:
While the results from Morgan and Goldman continue to shine some light on which banks were better managed during the financial bubble era, it doesn't affect my thinking regarding our small-cap universe in any significant way. Possibly more concerning is the impending bankruptcy of CIT Group. CIT's problems can be tied back to its decision to expand its participation in the toxic sub-prime lending market, but at its roots, CIT is a major supplier of credit to small- and medium-sized businesses. With this source of funding potentially disappearing, credit to support short-term working capital requirements will be harder to obtain. Finding companies with clean balance sheets and plenty of liquidity remains the watch word.

I am focusing on the health-care reform debate and believe there will be winners as well as losers when the final result shakes out. I like narrowly focused companies in niche markets, which actually offer potential cost savings to the health-care system. I've got my eye on one in particular, a company that has developed a disruptive technology in a space vital to health care. If true cost savings is a goal of health-care reform, this company should do well. (I have to keep it under wraps until I reveal it to our Hidden Gems members in the upcoming issue.)

Foolish final thought
Think we missed the obvious? Disagree or agree with our assessment? We want to hear from you. Let us know in the comments section.

The Hidden Gems team believes so strongly in its measured approach to small-cap investing that it's working with $250,000 of real money. Find out about the team's latest buy, an underloved small cap in the health-care sector, along with the rest of the team's thoughts on dozens of high-quality small caps, with a risk-free trial.

At the time of publication, Seth Jayson had no position in any company mentioned here. Mike Olsen owns shares of Ultra Petroleum. Stan Huber owns shares of JPMorgan Chase, Buffalo Wild Wings, and Dynamic Materials. Buffalo Wild Wings is a Hidden Gems portfolio candidate. Netflix is a Stock Advisor recommendation. The Motley Fool owns shares of Buffalo Wild Wings and Dynamic Materials and has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2009, at 4:38 PM, portefeuille wrote:

    Nate Weisshaar, Senior Analyst


    does he know that the meaning of Weisshaar is white hair? fits the "senior" title well ...

  • Report this Comment On July 16, 2009, at 6:25 PM, XMFSinchiruna wrote:

    I'll take a look at RINO ... certainly sounds like a budding industry to be involved in. Thanks for the tip! :)

  • Report this Comment On July 16, 2009, at 10:29 PM, DiscoFinance wrote:

    See the movie stock market chicanery "STOCK SHOCK." Amazon has it.

    Stock Shock is entertaining and disturbing at the same time but every American Investor should see it. Available only on DVD (of course!).

  • Report this Comment On July 17, 2009, at 11:56 AM, NotJesseL wrote:

    I think the CIT group problem will affect small business even more, which sector is already pretty strapped. 1 million small businesses having to find new financing is not pretty. Doesn't mean that they will all fail by any means. Add to that that the SBA has new fast credit lines they are pushing through the local banks called SBA Express line which is from 15 to 50K. So, its still chaotic, but the dust is settling IMHO. We might be talking about a new normal, - it means change for sure - but it might actually be a very good thing on the whole. List of potential good things:

    1.) less debt for consumers - more thoughtful purchases.

    2.) more shareholder control of corporations

    3.) Retirement evolving into working less as you get older.

    4.) Less consumption - better for the environment?

    5.) Shareholders do their own homework and don't trust the "Bernie Madoff" types any more.

    Well, here's hoping anyway.

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