Traditional investing logic tells us that, when the economy turns sour like it has, we ought to flock to undervalued large-cap stocks. Not only do they have better access to capital than smaller companies do, but they also attract the smartest and brightest business minds.
If the recent market implosion has taught us anything, though, it's that a poorly run large company can fall harder than a poorly run small company in an unforgiving market. In fact, some small companies have adjusted much better than their larger counterparts have.
Castles made of sand
Certainly there's still some merit in the conventional approach -- one could do far worse than buy quality names such as PepsiCo (NYSE: PEP ) and Johnson & Johnson (NYSE: JNJ ) at current prices, as both of these blue chips have solid balance sheets and continue to attract top talent.
Yet there was no shortage of talent wanting to get in the doors of Lehman Brothers, Wachovia, and Bear Stearns -- in fact, all three employers were among the 100 "most desirable" MBA employers in 2008, according to a Fortune survey. If traditional logic held true, this high-caliber talent should have been able to recognize the companies' problems and correct them more quickly than a smaller company could. As we all know, that reasoning failed many investors.
In fact, it's been the smaller and nimbler financial firms -- like Stifel Financial -- that have rolled with the market's punches. Stifel avoided subprime exposure, and in August, it reported that it increased quarterly net income by 28% year over year. As a testament to Stifel's strength, it recently acquired 56 of the struggling UBS's (NYSE: UBS ) wealth management offices in the U.S.
But it's not just the financials. Consistently poor execution at formerly large-cap American businesses such as Eastman Kodak (NYSE: EK ) and Ford has sent both stocks down to the single digits, with few signs of returning to their former glory. These companies employ tens of thousands and have had plenty of access to capital but simply failed to perform well over the years.
Now compare those giant tales of woe to the success of PetMed Express, a $360 million pet-drug prescription company that employs about 250 people. Last month, the company reported earnings growth of 12% year over year, remained free-cash-flow positive, and kept long-term debt off its balance sheet. In August, PetMed Express also announced its first-ever dividend payment.
Bucking the dividend trend
Another reason investors traditionally turned to large caps in this type of environment was for their consistent and reliable dividends, but after 62 S&P 500 companies cut their payouts in 2008 -- followed by another 75 cuts or suspensions so far in 2009, according to S&P data, from companies including Macy's, Morgan Stanley (NYSE: MS ) and Dow Chemical (NYSE: DOW ) -- it's clear (or clearer than usual) that no dividend is guaranteed.
Indeed, in a conference call after the dividend cut, Macy's Chief Executive Terry J. Lundgren said, "We just believe that this is a time when nothing should be considered a sacred cow."
It's discouraging to see so many blue-chip companies that have paid or raised dividends for decades suddenly changing course and blaming their mistakes on the macroeconomic picture, but there are still companies out there, large and small, staying true to shareholders with dividend increases in this market.
One of those companies is $3.4 billion clothing retailer Guess?, which, in August -- despite operating in the same consumer spending environment as Macy's -- increased its quarterly dividend by 25% on the heels of an increase in sales and profits for the quarter.
Guess? is able to do this because it isn't burdened by debt (it has almost no long-term debt), and it generates plenty of free cash flow. So it has plenty of room to raise dividends or reinvest in the business for the benefit of its shareholders.
Choose your weapons wisely
In a market where economic agility and strong management matter more than ever, make sure you're studying well-run small companies alongside larger companies. For my money, I want to own companies, regardless of size, that have a strong management team, have a rock-solid balance sheet, and dominate their market niche.
One of the companies I've been researching recently is Darling International, a $580 million company that fills a niche not many others want to fill: collecting food-service waste (grease and discarded meat) and rendering or recycling the waste into usable by-products such as animal feed, industrial oils, and even biofuel.
It's not only the largest company in this field (and the only one that's publicly traded), but it also has contractual relationships with big names such as McDonald's and Burger King (NYSE: BKC ) . It's a cyclical business, to be sure, but Darling has positive free cash flow, more cash than long-term debt, and tenured management -- so it's worth your time to research.
If you're looking for more small-cap ideas for this market, our Motley Fool Hidden Gems team can help. Among other things, they look for stocks that are:
- Underfollowed on Wall Street.
- Led by dedicated founders.
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- Dominant in their market niche.
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This article was originally published March 20, 2009, and has been updated.
Fool analyst Todd Wenning is an equal-opportunity investor. He owns shares of Johnson & Johnson, a Motley Fool Income Investor recommendation. PepsiCo is also an Income Investor pick. The Fool has a disclosure policy as fast as greased lightning.