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3 Small-Cap Stocks With Big-Cap Potential

By Lee Samaha – Updated Jun 24, 2020 at 4:33PM

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Two infrastructure plays and a renewable energy company have the potential to grow substantially in the coming decade.

If you are confident that various government entities in the U.S. are making the effort to maintain and enhance the country's infrastructure, then you probably are also confident that companies like Federal Signal (FSS -1.17%) and Alamo Group (ALG 0.57%) have a bright future. Meanwhile, fans of the growth of wind power in this country and elsewhere will want to take a look at composite wind-blade manufacturer TPI Composites (TPIC -2.49%).

All three of these small-cap stocks -- small-cap being a reference to companies with market capitalizations under $2 billion -- have the potential to advance to mid-cap status and even reach the $10 billion market cap minimum that begins to designate them as large-cap stocks.

Here's a breakdown of these three companies and why they show such promise to make the large-cap leap.

A man standing in front rising money.

These three stocks are thinking big. Image source: Getty Images.

1. Alamo Group: Current market cap of $1.12 billion

Alamo's management describes the company as a leader in infrastructure maintenance and agricultural equipment. As such, it operates out of two divisions, namely industrial and agricultural.

The industrial division manufactures a wide range of equipment in niche markets such as sewer cleaning equipment, highway excavators, industrial mowers, snowplows, and even river trenchers. Meanwhile, the agricultural division provides mowers, pickers, and landscaping machinery to farmers and ranchers.

It's an eclectic mix of products and services and one that's been built up through the acquisition of 27 businesses since 2000. Alamo sales have more than doubled in the last decade and totaled $1.1 billion in 2019, with around $770 million of that revenue coming from the industrial division and $350 million from the agricultural businesses.

Alamo's growth opportunity comes from consolidating a highly diverse and fragmented market by continuing to make acquisitions. In addition, as it grows, it will find it easier to expand geographically and cross-sell its equipment to existing customers.

Its expansion plans are made with the knowledge that its end demand is backed by the need for government spending to maintain existing infrastructure, so Alamo is well placed to continue growing.

Turning to its valuation, the COVID-19 pandemic has taken its toll on nearly all companies, and analysts have Alamo's earnings per share declining to $4.42 in 2020 from $5.92 in 2019. Nevertheless, as revenue and earnings recover in 2021, the forward price-to-earnings ratio of 15.8 looks like a decent value for a company positioned in stable end markets. The company's stock is currently trading at a forward P/E of 15.8, suggesting the price is currently discounted.

ALG PE Ratio (Forward 1y) Chart

Data by YCharts.

2. Federal Signal: Current market cap of $1.73 billion

Like Alamo, Federal Signal owns a collection of niche businesses serving municipal and industrial customers. Over 80% of its sales are generated by its environmental solutions group (ESG), which provides municipalities with a range of surface and sewer cleaning equipment, road digging and marking equipment, and industrial cleaning machinery.

The rest of its revenue comes from its safety and security systems group (SSG), a motley collection of signals, sirens, and warning systems used by the police, municipalities, and industry.

It's also a business that has experienced strong growth over the last decade, driven by acquisitions and supported by underlying demand for municipal spending on infrastructure.

ALG Revenue (TTM) Chart

Data by YCharts. TTM = trailing 12 months.

Management believes a combination of organic growth in excess of GDP and targeted acquisitions will lead to high-single-digit revenue growth. Like Alamo, the company is set for a COVID-19 earnings decline in 2020. But as the first chart above indicates, a forward P/E in the mid-teens makes it an attractive option for a company with growth opportunities within relatively stable end markets.

3. TPI Composites: Current market cap of $785 million

As the cost of wind power continues to fall, it's likely to become more competitive as a source of electricity production. As such, demand for the technology behind this renewable energy source should go up. That's the fundamental investment case for TPI.

The company is the largest U.S. independent manufacturer of composite wind blades, and its customer list reads like a roll call of the leading wind power companies. Vestas, Siemens Gamesa, and General Electric (GE -0.19%) are among its largest customers, and its existing contracts provide for $5 billion in revenue through 2023. For reference, the company generated $1.44 billion in sales in 2019.

There are probably three key drivers of long-term earnings growth. First, there's the falling cost of wind power and increasing regulation of less environmentally friendly technologies. Indeed, General Electric's management believes this will drive growth in the renewables industry

Second, there's the trend toward manufacturers outsourcing production of blades. According to TPI, only 38% of wind blades were outsourced in 2009 (as opposed to in-house manufacturing), but in 2019 that figure was 63%. Even GE, which acquired a major blade manufacturer in 2017 (LM Wind Power) for $1.65 billion, is expected to continue to significantly outsource production.

Onshore wind turbines.

Onshore wind turbines. Image source: Getty Images.

Third, the movement toward larger blades will benefit TPI as it tends to build longer blades for the industry.

While there's no guarantee that TPI's customers will expand existing contracts in the future, wind power is clearly a growth industry. And as an independent producer, the company may be favored as a provider over a company like GE's LM Wind Power. All told, TPI looks well set to profit from growth in the industry.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends TPI Composites. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Alamo Group Inc. Stock Quote
Alamo Group Inc.
$121.51 (0.57%) $0.69
Federal Signal Corporation Stock Quote
Federal Signal Corporation
$38.06 (-1.17%) $0.45
TPI Composites Stock Quote
TPI Composites
$12.12 (-2.49%) $0.31
General Electric Company Stock Quote
General Electric Company
$64.35 (-0.19%) $0.12

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

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