FOOL ON THE HILL

Four Smart Small Caps

Precious few companies have a three-year track record of positive cash from operations, a balance sheet with more cash than debt, a stock price above $5, and a valuation less than 10 times free cash flow or earnings. Most such companies are small and have been overlooked by Mr. Market. We consider four small caps today and highlight one standout: Hampshire Group.

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By Matt Richey (TMF Matt)
October 15, 2002

This is Part 2 of a series on finding undervalued small caps. Why small caps, you ask? Because that's predominantly where I'm finding value.

Even after all the carnage over the past few years, the S&P 500 still trades for a lofty 19.2 times earnings and 1.2 times sales, according to investment manager Barra. Yes, lofty. Throughout the 1980s and early 1990s, the S&P 500 always traded below 1.0 times sales, and often closer to 0.5 times sales. That's why I'm steering clear of most large caps in favor of little-known, but much more reasonably valued small caps.

In this series, we're looking at 16 promising small caps. Last time, I gave you a thumbnail overview on four companies, and today we'll consider four more. This isn't deep analysis, just a first-cut look to determine whether I (and perhaps you) might want to follow up later with more in-depth research. My hope is that by the end of the series, we'll have at least one or two real gems worthy of a more thorough investigation.

These companies don't have sexy businesses and certainly don't receive much attention from the financial press. But these are among the select few publicly traded companies that offer a three-year track record of positive cash flow from operations, a balance sheet with more cash than debt, a stock price above $5, and a valuation under 10 times free cash flow or earnings. Their businesses may be mundane, but there's nothing boring about the cash they generate and the potential returns they could deliver to investors.

So without further ado, let's start turning over some rocks and see what we find.

Hunt Corp. (NYSE: HUN)
Hunt is a turnaround story showing signs of success. The company has a stable business of selling low-priced office and art/framing supplies under the well-known Boston and X-Acto brand names. You're probably familiar with some of its pencil sharpeners, staplers, and paper trimmers.

Hunt has been in restructuring mode for the past several years, leading to a much more streamlined organization. Last year, the company divested its commercial graphics products business for $32 million and used the proceeds to pay down its long-term debt. At the same time, Hunt has used weakness in its stock price as an opportunity to repurchase a substantial portion of the company. Over the past three years, it has repurchased a total of 2.1 million shares, thereby reducing its share count by 19%.

So far this year, Hunt's lower cost structure has allowed it to increase pre-tax operating income by 22% to $12.2 million, even while sales drifted down about 1%. For the 12 months through June, free cash flow totaled $9.87 million on $160.3 million in sales. That's a free cash flow margin of 6.2%, which isn't half bad. The stock, at $9.10, trades for about 8.3 times free cash flow, plus $0.57 in cash per share. Also, the stock offers a tasty dividend yield of 4.5% -- a yield that appears to be secure based on current levels of free cash flow.

Koss Corp. (Nasdaq: KOSS)
Koss makes stylish stereo headphones, but its real talent is smart capital allocation. Over the past three years, the company has repurchased 25% of its share base, leading to share price appreciation of almost 200%. The stock's strong performance is mostly a function of its former dirt-cheap valuation: Three years ago, the stock was trading for around five times free cash flow.

Operationally, the company shines for its stellar return on invested capital of 27%, up from 13% four years ago. But what's lacking is any top- or bottom-line growth. Sales have been more or less flat for seven years. Similarly, net income has been stagnant for the past three years. With no signs of growth on the horizon, the stock at $15.50 looks fairly valued at 8.0 times free cash flow and 12.0 times earnings. Yet, even at a fully valued price, income-focused investors may want to consider this one for its 3.4% dividend yield.

Hampshire Group (Nasdaq: HAMP)
Hampshire makes a surprisingly good business out of selling sweaters. Through its Hampshire Designers segment, which has been in operation since 1956, the company is the largest designer and marketer of sweaters in North America. In addition to sweaters, it also sells women's sportswear through its Item-Eyes division, which Hampshire acquired in 2000. Overall, the company focuses on moderately priced apparel, including sales to department stores, mass merchandisers, specialty stores, and mail-order distributors. Over the past seven years, sales per share -- which factor in the impact of stock buybacks -- have increased at an impressive 10.2% compound annual rate.

In 2001, sales growth was a solid 8.2%, and that's not even including the incremental sales from the acquisition of Item-Eyes. Including the acquisition, Hampshire's sales increased 33.8% in 2001. So far in 2002, sales have continued their strong pace, growing 17.9% without the help of any acquisitions. Also, by discontinuing a less profitable product line, the company boosted its gross margin to a record-high 28.7%, up from 20.6% in the year-ago period. The higher gross margin allowed Hampshire to earn a modest profit for the six months through June, normally the seasonally weak quarters of the year, versus a loss in the year-ago period.

At $16.50, Hampshire trades for an amazingly low 1.6 times free cash flow and 5.1 times earnings. Focus on the earnings multiple in this case, because Hampshire's free cash flow over the past year has been temporarily bolstered by tight management of inventory and receivables (a good thing, but only a one-time event). With a 23% return on invested capital and a management team that owns 49% of the company, this is one I want to examine more closely.

Blair Corp. (AMEX: BL)
Blair is an apparel catalog retailer of value-priced men's and women's clothing. On its home page, the company hails itself as the nation's ninth-largest consumer apparel cataloger. Similar to Koss, Blair's business is mature and slow growing, and thus the growth in the per-share value of the business is primarily a result of stock buybacks. In 1999 and 2000, Blair repurchased almost 1.3 million shares (about 14% of the company) for an average price of $17.48 per share.

Sales growth has been minimal over the years: Since 1995, sales have grown at a 1% compound annual rate. Even when you factor in the stock buybacks and look at growth in sales per share, the growth rate is still a meager 3.6%.

Overall, the company has done a good job of using its cash to pay off debt, repurchase shares, and pay a decent dividend (currently yielding 3.2%). At $19.25, the stock trades for 9.0 times earnings, which seems like a fair price for a no-growth business.

Conclusion
Among the companies we looked at today, I'm most interested in digging deeper into Hampshire, although Hunt is intriguing as well.

By the way, I appreciate all the stock ideas you guys are sending me. Please keep 'em coming, including, of course (as most of you have done), an elevator-style pitch for the investment thesis. I expect to write about some of these in the coming months. Also, if you have any insights into the companies I've written about today, I'd love to hear your thoughts (MattR@fool.com).

Next Tuesday, I'll continue this series with a look at four more promising small caps. Stay tuned.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. For Matt's best Foolish stock ideas and analysis that you won't find anywhere else each month, check out our unparalleled newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.