Small-cap stocks tend to be under-researched and under-followed, and this can sometimes create buying opportunities for investors willing to go the extra mile to find them. What's more, they can come from a variety of industries and give you exposure to fast-growing or even nascent markets.
Let's look at three that stand out today. AAR Corp (AIR -3.77%) is a play on the growth in commercial aviation and the need to service aircraft. Federal Signal (FSS -2.58%) benefits from increased municipal, industrial, and utilities spending on environmental solutions (street cleaning, safe digging, etc.), and Altra Industrial Motion (AIMC) is a play on a potential recovery in motion control and power transmission product end markets.
AAR Corp for its commercial aviation exposure
The company is a global provider of aviation support services to the commercial and military markets. In plain English, this means supplying parts as well as repair and engineering services to airlines. Customers include major airlines such as Delta, Lufthansa, Southwest, and United Airlines as well as FedEx, UPS, and the U.S. Air Force. As such, AAR works with the leading original equipment suppliers such as General Electric, United Technologies, and Northrop Grumman.
The key to its long-term growth prospects are the health of the commercial aviation market -- a very strong market at present, as the results of United Technologies and others attest -- and specifically, the number of "shop visits" made by aircraft that need airframes and, more importantly, engines serviced and overhauled.
It's a great market to be in as worldwide airline profitability and passenger growth remains in robust growth, and both United Technologies and General Electric are bullish on the aftermarket opportunity for long-established engines like the V2500 (Airbus A320 family) and the CFM56 (Airbus A320 family and Boeing 737 family).
AAR's management sees the company as growing organic sales at a 5% to 10% annual rate over the long term and EPS growth of 10% to 12%. Analyst forecasts are for a combination of mid-single-digit revenue growth and low-teens EPS growth for the next couple of years. With the stock trading at less than 17 times next year's EPS forecast of $2.61, it looks like a good value for its long-term growth prospects.
Federal Signal as a play on infrastructural growth
Federal Signal's environmental solutions group (responsible for nearly 80% of segment operating income in the first three quarters of 2019) manufactures a range of machinery and trucks used for street sweeping, sewer and industrial cleaning, safe digging, and road marking. As such, it's a small-cap stock with a play on servicing and maintaining infrastructure in the U.S. 82% of total company revenue comes from the domestic market. Given aging infrastructure and the increasing trend toward urbanization, the company should have good long-term growth prospects.
Management is aiming for "long-term organic revenue growth of a couple percentage points above GDP." In addition, management plans to augment organic growth by making acquisitions such as Mark Rite Lines, a road marking equipment company, for an initial purchase price of $55 million earlier this year. Management expects high single-digit revenue growth over the long term.
The company is on track to meet these objectives in the near term, with analysts expecting 11.6% and 7.1% revenue growth in 2019 and 2020, and the company recently reported organic orders growth of 8% in the third quarter, suggesting it can still grow even in an industrial slowdown.
Based on analyst estimates, the stock trades at 17.4 times estimated 2020 EPS of $1.90, a reasonable value for a company growing earnings at a double-digit pace. It seems worth buying if you believe spending on U.S. infrastructure is set for growth following a period of under-investment.
Altra Industrial Motion as a value play
Altra is undoubtedly a superficially cheap-looking stock based on its valuation metrics. Enterprise value is market cap plus net debt, and EBITDA refers to earnings before interest, tax, depreciation, and amortization. I've included this metric because Altra took on debt in order to combine its business with Fortive's former automation and specialty assets.
In the words, of Altra CEO Carl Christenson, the deal will enable the company to:
provide our customers with a broader suite of products and solutions, including sophisticated precision motors, drives and controls; engineered linear motion systems; miniature motors; and a leading portfolio of braking technologies.
Unfortunately, the timing of the deal (late 2018) came just as it became clear that the industrial sector was set to slow in 2019 -- not great news if you are supplying over 1,000 direct original equipment suppliers, including General Electric, Honeywell, and Siemens. As such, organic sales growth was down 3.6% in the recent third quarter, and analysts estimate sales declining 3.4% in 2020 with earnings declining nearly 4% to $2.72.
But here's the thing: Other motion control companies such as Parker-Hannifin are expecting an inflection point in their sales to occur next year, and some leading trucking companies (a key industry vertical for Altra) are expecting growth to return in 2021.
If Altra can hit estimates for 2020, and the economy avoids a recession, then industrial production is likely to pick up, meaning Altra's stock is very attractively priced right now.