What does it take to turn a small-cap stock into a big-cap stock? In a word: growth.
OK. That sounds obvious. So let's get more specific here.
In the words of Benjamin Graham, the famed investor who taught even more famous investor Warren Buffett how to invest: "In the short run, the market is a voting machine, but in the long run it is a weighing machine." So the thing that makes a small stock "grow" its market capitalization to big-stock size is something that you can weigh -- namely, really big piles of cash profit.
Which small companies today are growing their cash piles, and growing them fast enough that we can foresee a day when the market will reward them with large-cap valuations? Here are three for you to consider: AeroVironment (NASDAQ:AVAV), Kforce (NASDAQ:KFRC), and Masonite International (NYSE:DOOR).
The U.S. Army's go-to source for small military spy drones for years, AeroVironment has recently expanded its business to the commercial realm, introducing a Quantix vertical take-off and landing drone. Weighing in at a svelte five pounds and with a wingspan of only 3.2 feet, Quantix was designed for use by energy companies monitoring remote oil pipelines and agribusinesses surveying their fields, and was recently utilized by the National Park Service to monitor the effects of California wildfires.
At present, Quantix is just a side story next to AV's overwhelming success selling Raven and Switchblade UAVs to the military -- but it's the kind of side story that could evolve into a growth story over time.
Analysts who track AV's progress believe this company is capable of growing its earnings at better than 27% annually over the next five years. Investors are currently paying through the nose for this growth, with AeroVironment stock priced at more than 40 times earnings (and nearly twice that valuation relative to free cash flow, according to data from S&P Global Market Intelligence). If that seems a little extreme -- well, it is. On the other hand, though, it's also a measure of how enthusiastic investors are to own a piece of this long-term growth story. So long as AeroVironment's earnings continue flying in the right direction, its market cap should continue to climb higher.
One of the biggest names in the temporary jobs market, Kforce has been in business since the 1960s. If you were around during the dot-com boom and its aftermath, you might have known it as "Spherion," and most of the company's revenue growth has taken place since the turn of the millennium. At present, Kforce is a $1.5 billion-a-year-business, drawing 70% of its revenue from placing workers in the tech industry, and smaller amounts from its finance, accounting, and government jobs businesses.
2019 was a good year for all of the above, but technology especially. Kforce's net income for the last 12 months has more than doubled over 2018 levels. In the company's most recent quarterly report, management noted that both revenue and earnings per share in Q3 "exceeded the top end of our guidance." Kforce attributed this success especially to "new assignment starts in our technology business," confiding that as of now, tech -- a focal point of the new gig economy that's benefiting Kforce -- "has actually grown to represent 80% of the company's revenues."
Analysts don't have particularly long-range earnings targets for Kforce, but looking out over the next couple of years they're projecting earnings to grow a respectable 23%. Given the stock's current 6.2 P/E ratio, that seems plenty fast to justify a higher stock price -- and market cap. If Kforce can grow fast enough, long enough, and if the gig economy continues to grow, it might not be too much longer before tiny Kforce graduates to large-cap status.
Last but not least, Masonite International. Now, you might not think that "doors" would be a growth industry, but Masonite has other ideas.
From an estimated $2.23 per share earned in 2019, Wall Street analysts forecast that Masonite will nearly triple its earnings over the next three years, earning $6.39 per share in 2022. That would work out to an astounding 42% annualized earnings growth rate if the analysts prove correct, which would be more than enough growth to justify even Masonite's oversized 36 P/E ratio. But is there any good reason to believe Masonite can achieve this growth?
In fact, already Masonite's annual free cash flow -- $114 million -- is nearly twice its reported net income of $55 million. As these two numbers converge over time, earnings are likely to rise very fast indeed. In its most recent earnings report, Masonite management cited "higher average unit price[s]" and "continued operational productivity improvements" as factors helping to drive earnings higher. Management cautioned that with the U.S. housing market favoring entry-level homes "with fewer doors" right now, a shift in demand toward trade-up homes would be one factor to look for to improve Masonite's earnings even more.
Already, Masonite boasts a market capitalization of more than $1.9 billion -- still barely within the definition of a small-cap stock, and verging on mid-cap territory. If Masonite grows as fast as Wall Street thinks it will, it might not be all that long before we see Masonite achieve big-cap status.