Why a "Soup Sandwich"?
Once again, I suppose I'd better start by explaining that headline.
I was hitching a ride home with colleague Bill Mann the other day, and we were discussing something outlandish -- I can't remember what. Could have been William Hung's new movie career, or that shameless and puerile girly-crush plot line on The O.C.
At one point, Bill just shook his head and said, "That's as crazy as a soup sandwich."
If I'd been drinking milk in the school cafeteria, it would have come out my nose. The phrase stuck with me the next few days while I reviewed the companies that made it through my latest stock screen. It seemed an apt description of certain kinds of stocks that have multi-bagger potential. Tom Gardner or Michael Lewis might have called them "fat guys who don't get outs." I prefer the shorter title: Soup Sandwich.
As those who read Peter Lynch's books or our own Motley Fool Hidden Gems know, many of the world's best investments have been small companies that do something crazy or odd. The idea is that the business seems so trivial or wacky that no one takes notice, until the smell of money becomes too overpowering to ignore. When these firms are small, no Wall Street analyst can risk his career by recommending them for the portfolio at G. Starchyshirt and Co. (Ticker: STKUP.) "They make precision bearings for use in high-end office furniture? Get out of my office, smart guy! There'll be no new Porsche for you this year." Or, going back in time: "Dell (NASDAQ:DELL)? Come on, Smith! IBM and HP will kill those little punks."
Who wants to risk hearing that? Better to just buy the Street's flavor of the day, whether it's a good company that's already had its major ramp-up, like Apple (NASDAQ:AAPL), or an aging, established behemoth like Intel (NASDAQ:INTC) or Ford.
Ten-baggers, on the other hand, are much more likely to come from small-cap companies that are unnoticed or, better yet, unloved. Crazy-looking businesses. Soup Sandwiches. They're out there, waiting for us. But how do we find them?
The makings of a Soup Sandwich
Screening is one good tool, and it's something that has its own board at Hidden Gems. There are some great ideas there, but it's also fun to look for your own unloved companies.
Trouble is, this isn't Star Trek, or even Star Wars, so you can't just say, "Computer, get me a Soup Sandwich, hold the hedge funds." But, strangely enough, if you set your screen to look for certain indicators of real-life profitability, the crazies come to you.
Here's how I found a few Soup Sandwiches this month. I set up a screen that looked for companies meeting the following criteria:
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Market cap between $100 million and $1 billion. I'm interested in finding companies that are so small that the big investors won't, or even can't, take too big of an interest. Later, when the company grows, the big fellows are welcome to join the game and buy my shares at a hefty premium.
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Institutional ownership below 30%. Again, I want stuff that the Street is ignoring, for now.
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Insider ownership greater than 20%. Most of us Fools believe that the best way to ensure that management is working in our best interests is to make sure that they own lots of shares themselves.
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Growth in free cash flow exceeding growth in earnings per share over the past five years. If a firm is churning up cash at a better rate than it's churning up earnings, that's a pretty good indication that management is doing the right things.
- Enterprise value-to-free cash flow ratio positive, but less than 22. I want the firm to be selling for less than the cash-to-price metric carried by the market as a whole.
The contenders
First off, I'll note that this screen netted companies like Arden Group and Books-A-Million, firms that have just missed the cut at Hidden Gems -- they've made the Watch List but not the final round. A high-end grocer and a major bookseller aren't strange enough to make my list, anyway, so they're out right away. But when a screen starts pulling in the same kinds of companies that have become market whompers for Tom Gardner, I'll think it's a keeper.
On the other hand, the screen also brought in exactly the kinds of firms that would leave most investors screaming and heading for the exits, or at least scratching their heads. Fans of freaky small caps should take a look at the following.
- Mmm. hazardous waste. If ever a business sounded scary, American Ecology (NASDAQ:ECOL) does. Got medical waste, other toxic industrial waste, radioactive yucko? American Ecology takes care of it for you. It also seems like one of those investments Lynch would have loved because others would hate it. He had an affinity for waste-hauling firms and other businesses that suffer from the stereotype of being controlled by the mafia. American Ecology's recent financial results showed slimmer revenues -- in part because of a fire at a waste facility -- but also a modest gain in earnings. At a sub-10 price-to-earnings ratio and an EV/FCF ratio around 13, the firm is certainly much cheaper than what you could find on the rest of the market. And at a market cap near $200 million, it has plenty of room to grow.
- If there's one thing tastier than nuclear waste, it must be pork. Just ask Homer Simpson. If he had stayed in Rio, he could've become a fan of Sadia (NYSE:SDA). I wrote about this company a while back, when I was screening for foreign investments. I won't belabor you the full description again, but if a Brazilian pork producer is strange enough to pique your interest, then take a closer look. This firm is hidden in plain sight, like Poe's stolen letter. Mention the name up here, and you'll likely draw a blank, but Sadia is the biggest name in food processing in Brazil, and it's one of the country's most trusted brands. It's also a major exporter. While its business is subject to creepy-looking Brazilian two-share structures, as well as cyclical concerns that afflict any commodity business, I think Sadia's prominence makes it a slightly different beast. And the shares are a bit cheaper than they were a few weeks back.
- Moving across the Atlantic and back toward industrial waste, the screen brings in a construction and environmental consulting group, Arcadis (NASDAQ:ARCAF). In my best Goldmember voice: "They're Dutch. Ishn't dat veerd?" The firm specializes in projects like tunnels, groundwater treatment, and traffic control. If you've ever traveled in the Netherlands, you might agree with my inkling that there's no culture more qualified to deal with such issues than the Dutch. These are people who, when they want land, just take it away from the sea. Not enough to persuade you to dig a bit deeper? Well, you cheapskates out there should appreciate this: The $400 million company trades at a P/E just north of 14. Yes, P/Es are always lower in Europe, but an EV/FCF ratio of 7 suggests that the firm produces ample cash for its size. It jumped 5% yesterday on the news that it was divesting itself of some U.S. operations to concentrate on core competencies. In our view, focus is good. Cheap focus? Definitely worth a double-take.
- Let's finish up with software. Not strange enough? Hang on there, Sunny Jim. This is special software, the stuff that runs "hospitality" businesses, like hotels, or those food-ordering terminals at McDonald's. Yup, you benefit from this stuff every day, but you barely notice it. Someone's got to make it. And PAR Technology (NYSE:PTC) is one company that does. It's one of the smaller players in the field, but it looks as though it's doing good things. Yesterday's Q4 results boast 25% revenue growth, to record levels, as well as a much heftier, triple-digit jump in EPS. A brief glance at the $127 million company shows a P/E near 23 on the new earnings, but much cheaper-looking EV/FCF ratio of 8 for the trailing four quarters before the latest. Increasing returns on equity and assets suggest that this company is another little weirdo worth a deeper look.
The Foolish bottom line
Are any of these companies really worth our investment buck? It will take a bit more digging to find out. One thing I know for sure is this: Ample evidence suggests that good small companies that are just too strange for the rest of the Street do have market-beating potential. You'll be a better investor if you enjoy flipping over rocks and looking for strange treasures that the rest of the world is missing. So be on the lookout for the occasional Soup Sandwich. And if you've got any really great ones, feel free to share them with us, via my email link below.
For related Foolishness:
- See why we like focus.
- Should you fear the foreigners?
- How do you find the next home run stock?
Sometimes, Seth Jayson just likes looking at companies for the funsies. At the time of publication, he had positions in no firm mentioned. View his stock holdings and Fool profile here. Fool rules are here.
