10 Small Caps to Rule Them All

Small-cap companies are one of my favorite areas to research, because you can often uncover great stocks that analysts have neglected or simply not discovered yet. These tiny businesses can offer the ultimate risk-vs.-reward ratio, but they're not for the faint of heart.

I've dedicated this 10-week series toward finding the 10 small caps to rule them all. Here are the previous seven choices:

This week, I want to put volatile growth aside and dig deep for value in the insurance sector with Tower Group (Nasdaq: TWGP  ) .

What it does
Tower Group offers a range of commercial and personal insurance products, predominantly in the northeastern U.S. In its most recent quarter, the company reported a 55% jump in year-over-year revenue, as well as a 28% boost in profits. To explain this robust expansion, the company cited premium growth from the recently purchased personal line division of OneBeacon Insurance Group.

How it stacks up
As you'll see, even being the most attractively priced stock in the property & casualty sector isn't enough to save Tower from a seller's onslaught.

The company outlined three reasons why it expects near-future challenges to its earnings potential:

  • Record-low interest rates are taking a toll on Tower's investment portfolio, and they continue to pressure its net investment income.
  • Upgrading its information technology platform will boost near-term expenses, but leave the company well-positioned for future growth.
  • Accounting changes to deferred acquisition costs are expected to temporarily eat into Tower's bottom line.

While these short-term setbacks might seem disappointing, the company remains perfectly set up for long-term success, making it a much more intriguing play than all of its larger rivals.

Company

Forward P/E

PEG Ratio

Dividend Yield

Tower Group

7.2

0.36

2.3%

Greenlight Capital (Nasdaq: GLRE  )

6.7

1.25

N/A

Progressive (NYSE: PGR  )

13.0

1.72

1.9%

Chubb (NYSE: CB  )

11.0

1.20

2.5%

Travelers (NYSE: TRV  )

10.0

1.14

2.3%

Allstate (NYSE: ALL  )

9.0

1.09

2.6%

Data from Yahoo! Finance.

In this case, size does indeed matter. Tower Group is a smaller company, yet still able to deliver a larger amount of cash flow from operations -- $170 million last year. That leaves Tower free to pursue countless joint venture and acquisition opportunities that can immediately add to its bottom line. In a predominantly slow-growth sector, Tower is finding new ways to make such smart moves.

You'll notice from the figures above that many property and casualty insurance companies trade at single-digit forward P/E's. The big differentiating factor comes from future growth rates, and here, Tower blows everyone else out of the water. Despite paying a dividend that matches most of the big boys in the sector, Tower Group is expected to grow at rates double or triple that of its rivals over the next five years.

Based on its cash-rich balance sheet and a quick comparison to its larger rivals, Tower Group appears to be a play that could pay. Now let's look at whether or not these utopian figures could translate into actual results.

How Tower could make you money
Everything that I find attractive with Tower Group begins with its fiscally conservative money management. The company's "shareholders first" approach should add stability and income to your bottom line. As stated, Tower already pays out a 2.3% annual yield. Possibly even better than the dividend, the company initiated another $100 million share buyback, in addition to the $10.2 million it still has remaining on its previous $100 million buyback announcement.

Why is this important?

  • A buyback is an investment directly back into the company, often signaling that management feels its shares are undervalued.
  • It reduces the amount of shares outstanding, which in turn can boost EPS figures, since they are compared against fewer outstanding shares. Assuming Tower is undervalued, this is probably a value-enhancing move.

Tower also exerts tight control over its expenses, and it has remained prudent in its underwriting practices, despite challenging times. In its annual filing, all segments of Tower's underwriting business were profitable, with its personal lines division showing the biggest improvement. Year-over-year figures for the segment improved dramatically, from a combined ratio of 107.4 -- essentially meaning the company was losing money by underwriting personal line policies -- to 86.4, while customer retention rates rose to 83%. Lower claims and a 5.2% jump in premiums padded Tower's bottom line.

Finally, having already jumped $500 million over the past year, Tower's $2.6 billion investment portfolio stands to yield significantly more net interest income once record-low interest rates begin to rise. Right now, most investors seem to ignore that fact.

Tower trades at just seven times forward earnings, and close to its book value of $26.22 per share. With a stable dividend, a shareholder-friendly approach, and an acquisition-laden growth strategy, I see no reason why Tower shouldn't excel for shareholders in the years to come.

What's your opinion on Tower Group? Is the company built for success, or is this a value trap in disguise? Share your ideas in the comments section below, and consider tracking my prediction by adding Tower Group to My Watchlist.

Fool contributor Sean Williams owns shares of Golden Star Resources but has no material interest in any other companies mentioned in this article. The only premium he enjoys paying for is Starbucks coffee. You can follow him on CAPS under the screen name TMFUltraLong. Buffalo Wild Wings is a Motley Fool Hidden Gems selection. The Fool owns shares of Allegiant Travel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is the Chuck Norris of disclosure policies.


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