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3 Top Small-Cap Stocks to Buy in October

By Maxx Chatsko - Oct 4, 2017 at 6:45AM

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These smaller companies hold big potential.

Even though Halloween is coming, don't let all small-cap stocks scare you. While it's generally true that smaller businesses present higher risks to investors than larger companies do, they may also offer the potential for outsized returns. Therefore, it may be worth it to take the long-term view on a promising small-cap stock in hopes that it grows its market cap steadily over time.

With that in mind, if you're looking for some top small-cap stocks to buy in October before 2017 comes to a close, then consider enzyme leader Codexis (CDXS 9.68%), genetic-testing leader Invitae (NVTA 9.25%), and the world's second-largest ethanol producer, Green Plains (GPRE -4.58%).

A bar chart drawn on a chalkboard showing growth.

Image source: Getty Images.

Enzymes are big business for this tiny company

When I wrote in mid-August that Codexis could be set to pop, I meant it might start making a bit more noise in the second half of 2017. It didn't want to wait, however, and is up about 31% in the past month and a half. There isn't any company-specific news driving the jump, but it's about time Mr. Market caught on to everything going right for the small-cap enzyme leader.

Codexis designs, engineers, and manufactures enzymes that increase the efficiency and speed and lower the energy required and waste produced during chemical production. The company's main customers are in the highly regulated pharmaceutical industry. They tap the company's expertise to increase production yields of high-value active pharmaceutical ingredients (APIs) and avoid the creation of toxic byproducts that are expensive to properly discard. Although highly regarded in industry circles for years, the technology platform -- and its business model -- is only now starting to catch on.

CDXS Chart

CDXS data by YCharts

First-half 2017 product sales grew 74% from the year-ago period, and full-year 2017 guidance calls for that trend to hold for the second half as well. Total revenue for this year could top out at $53 million if Codexis receives an upfront milestone payment from a yet-to-be-announced pharma company. Meanwhile, growing revenue by double-digit clips for the foreseeable future seems too easy, given the full range of growth projects spanning pharmaceutical production to DNA sequencing. Oh, and it expects to begin clinical trials for its own biological drug in 2018. 

While pharma applications have driven Codexis's business in recent years, and will continue to do so for the foreseeable future, there are various chemical manufacturing processes that can benefit from enzymatic magic. Indeed, food ingredient and specialty chemical markets comprise the second largest share of the company's revenue and growth potential. They could outgrow pharma in the long run simply because of the volumes of product involved.

The $330 million company isn't profitable today, but its net loss has shrunk from $41 million in 2013 to just $8.5 million in 2016. Considering that double-digit growth should continue for the foreseeable future, and that product gross margin (before factoring in cost-free milestone payments) exceeds 40%, investors should expect routine positive EPS before the end of the decade. Simply put, I think Codexis is one of the top small-cap stocks flying under the radar today.

Taking genomics mainstream

Invitae has an ambitious vision for the future of genomics: that anyone, anywhere, will have access to his or her own genetic information and use it to inform personal health decisions. There's just one thing standing in the way: the industry-standard business model.

Historically, genetic-testing companies have made a living by selling low volumes of tests for ridiculously high costs. Invitae wants to flip that on its head. Instead, it will make ends meet focusing on selling large volumes of high-quality tests at prices that allow them to be used by anyone's doctor. So far, so good.

NVTA Chart

NVTA data by YCharts

The genetic-testing company processed 30,500 tests in the second quarter of 2017, compared with just 12,500 in the year-ago period. The higher the volume, the lower the cost per sample, which has fallen from $500 per test to just $345 per test in the same period. Invitae's play is that the widening gap between the growth of test volumes and operating expenses will enable profitable operations in the future. 

It may very well be correct. However, building out operations and platform reach to increase the likelihood of long-term success has been painful for investors so far. Invitae has relied heavily on share offerings to finance its expansion and acquisitions, which have eaten away at shareholder gains.

NVTA Chart

NVTA data by YCharts

The good news is that the fast pace of growth promises to reverse the $100 million-per-year net loss sooner than most companies could ever dream of. The bad news is that dilution remains an attractive fundraising method for management. That said, it's important to remember that Invitae has only posted positive gross margin for three quarters now, so it's still pretty early in this company's trajectory.

Investors willing to stomach volatility and take a long-term view may want to keep an eye on this small-cap stock, perhaps with a small position. However, it may be best to add shares over time to counteract the inevitable dilution in the coming years.

A beaten-down ethanol leader

Green Plains is the world's second-largest ethanol producer, boasting annual production capacity of 1.5 billion gallons. While ethanol may not be the most popular chemical product, popularity doesn't negate the fact that it remains a valuable renewable chemical in global markets. Yet the company currently trades at just $850 million. It doesn't make a whole lot of sense once you dig deeper.

GPRE Chart

GPRE data by YCharts

On one hand, an unusually sluggish second quarter for American ethanol compounded an ongoing glut, which slashed profits for the industry. Green Plains wasn't spared, and Wall Street didn't waste time cutting its projected future earnings potential.

On the other hand, there are reasons you shouldn't care about any of the short-term concerns facing the industry. Green Plains has specifically worked to diversify its earnings away from ethanol production, such that it remains profitable when the bread-and-butter business falters and absolutely blows the doors off when American ethanol is firing on all cylinders. Wall Street seems to be overlooking that.

Consider that Green Plains is now the world's largest producer of food-grade vinegar (the main input is food-grade ethanol) and is found in leading brands from Heinz to Frank's RedHot to Hungry-Man. It's even the vinegar supplier to Windex. Why stop there? The company is currently the country's fourth-largest cattle feedlot owner (the main input is dried corn byproducts from the ethanol manufacturing process), boasting a meat offtake agreement with Cargill. 

In all, non-ethanol segments are expected to deliver up to $160 million in EBITDA in 2017 and up to $190 million in 2018. That's over 60% of total EBITDA expected for the current year despite making up a fraction of total revenue. Simply put, Green Plains is poised for a breakout... eventually. Patient buy-and-hold investors have the opportunity to start a position in a great company at criminally low prices. 

What does it mean for investors?

There are solid arguments to be made that Codexis, Invitae, and Green Plains are three small-cap stocks worthy of further consideration this October. Despite being the smallest, Codexis is, in my view, the best of the three. Barring a delay in closing its third major license agreement, there isn't much that can derail the company's momentum and multiple avenues for growth.

While I'm very intrigued by Invitae in the long term, there are certainly more quarters of losses and dilution ahead for investors. That's why starting a small position and adding over time could be a better strategy for the genomics visionary. Meanwhile, Green Plains has been at the top of my watchlist for a long time now, but the irrationality in renewable-fuels markets has kept a lid on ethanol stocks for over a decade. I'm optimistic that non-ethanol businesses will change that over time, which makes it a top small-cap stock for long-term investors.

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Stocks Mentioned

Codexis, Inc. Stock Quote
Codexis, Inc.
CDXS
$11.44 (9.68%) $1.01
Green Plains Inc. Stock Quote
Green Plains Inc.
GPRE
$26.87 (-4.58%) $-1.29
Invitae Stock Quote
Invitae
NVTA
$3.07 (9.25%) $0.26

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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