2 Small Caps You Can Understand

When I first hear the thick Spanish accents, I worry that I might not be able to make out what is being said in Gruma's (NYSE:GMK) conference call. But I end up comprehending everything perfectly, a feat no doubt aided by the inherent understandability of Gruma's business -- it's a Mexican producer of corn tortillas and processed corn products. Truth be told, it's more often the case that technology firm management and analysts are the ones who seem to be speaking in foreign tongues to me.

Besides precious understandability, Gruma has a lot of what I like in a stock. It has a small market cap, which keeps the biggest investing fish out of its waters. It has a slightly boring business, which likewise keeps the bubble-and-hype crowd away. And its growth estimates -- admittedly the consensus of a lone Wall Street analyst -- call for a whopping (for this kind of business) 16% yearly rise in earnings over the next five years. That gives the company a price-to-earnings-to-growth (PEG) ratio of only 0.65. If you aren't going to take the bait and click on that link (wait, here it is again), 0.65 is an attractive valuation.

Some might argue my semantics, but I consider equity investing to be educated gambling. As such, it makes sense to stack the odds in your favor, which stocks like Gruma do. By reducing institutional influence, their small market caps increase the likelihood of pricing inefficiencies -- a good thing for an individual investor looking to score a passed-over bargain. And semi-boring stocks are even more likely to be overlooked. Most important, though, is the "understandable" part, as that's where individual investors are arguably most likely to go wrong, buying companies they don't understand and signing up for risks they didn't realize they were taking.

Of course, even understandable stocks have risks. Despite Gruma's simple business, I'm nervous about investing south of the border -- not that I wouldn't do it, it's just that I think it's important to acknowledge that you can never know for sure what's inside the pinata. They do things differently down there: As of year-end 2002, for example, Gruma's outstanding loans to controlling shareholders totaled 27% of net income! (The balance for 2003 was much lower.) Finally, volume on the company's American depositary receipt is paper-thin, so if you buy, do so with limit orders and be ready for some swings.

To Gruma's credit, it enjoys competitive advantage as a market leader arising from superior technology and, presumably, superior distribution channels. And though earnings seem a bit smooth, they're growing:

I'm especially excited about increasing sales in the U.S., where half of Gruma's revenue already comes from, and where it benefits from partnerships with Archer Daniels Midland (NYSE:ADM). Add in the current 3.64% dividend yield and Gruma might be the best of the four small caps featured in this two-week series. But that's for you to decide.

In addition to Gruma, I found three other stocks that I feel meet these criteria, and also have the potential for decent -- not frenetic -- growth ahead of them. I'll stress that these aren't "run out and buy it because I said so" stocks -- if you want that kind of confidence, you'll have to subscribe to our Hidden Gems newsletter -- but they are solid ideas that should lay the foundation for some further research. I only have room for one more today; next week I'll unveil the other two.

Tuesday Morning
I can't help but wonder how much more successful this discount retailer of name-brand closeout and overstock home merchandise would be without a name like Tuesday Morning holding it back. I mean, come on -- Tuesday is categorically considered to be the cheesiest day of the week. Just look at its TV lineup.

What I do like about Tuesday Morning (NASDAQ:TUES) is its format: Unlike your typical Wal-Mart (NYSE:WMT), Target (NYSE:TGT), or Bed Bath & Beyond (NASDAQ:BBBY), Tuesday's only open 250 days a year -- not at all in sluggish January and July -- and sells via about 10 multiweek sales events per year. This not only keeps costs down but also creates a feeding-frenzy atmosphere among its target middle-aged women customers. In other words, it's not just selling products at 50% to 80% off; it's selling the hype of an event-oriented sale. And, since the merchandise varies by event, the company is selling the thrill of discovery -- the "treasure hunt" feeling as they call it. It seems to work, as I've heard these sales events are often mob scenes.

I don't fully understand the excitement -- maybe it's my Y chromosome -- but I know a good business when I see it. You have to respect a company that can actually add value while cutting costs.

Let's try to confirm this numerically by looking at what's arguably the most important operating metric: return on invested capital. Businesses take in money from capital markets to start up and to grow. But the providers of that money expect minimum interest rates in return, either through direct payment or value appreciation. These rates are represented in sum as weighted average cost of capital (WACC), and a company's after-tax operating return must be sufficient to cover its WACC.

It's like getting a bank loan at, say, 7% to start a business: After accounting for inventory purchases, operating costs, and taxes, your business had better be left with a return of at least 7% (called the return on invested capital or ROIC). Companies may out-earn their WACC initially, but generally end up making close to their WACC as their businesses mature and competition settles in. I didn't do a full WACC computation for Tuesday, but I'd guesstimate it's a little under 10%, admittedly give or take a few percentage points. Meanwhile, the ROIC is not only much higher, but it has actually been improving.

This is a very good sign for a business; Tuesday Morning should continue to build shareholder value for a long time to come. It's currently adding 65 or so stores a year, which leaves plenty of time before its stores -- currently around 600 -- reach the company-predicted saturation limit of 1,000.

But everything has weaknesses. With a PEG of 0.87, Tuesday Morning doesn't seem to be a hotbed of irrational exuberance. My biggest worry is that the past few years of low interest rates and copious homebuying have made sales -- and investor expectations -- unsustainably good. However, I do feel safer with a deep discounter in this regard.

Finally, Tuesday Morning has intermittently gotten into legal trouble for selling knock-offs of brand-name stuff. Maybe that's normal in the closeout business, but although things have worked out so far, a major judgment or settlement could set the company back. And that's assuming this knock-off stuff is accidental. And speaking of knock-offs, there's always the risk of a direct competitor emerging. Thursday Afternoon, perhaps?

Be sure to tune in again next Wednesday when I talk about two more easy-to-understand small caps: one that will literally light your fire and another you'll be happy to take fishing with you.

You can start a no-risk subscription to Tom Gardner's Hidden Gems right now by checking out our free trial offer.

Fool contributor James Early, who watches less than an hour of TV per month (and never watches on Tuesdays), owns none of the stocks mentioned in this article. He notes that some numbers have been adjusted or normalized for greater analytical accuracy.