Wall Street pros have nothing on retail investors who stake small sums of money monthly on undervalued small-cap stocks. Because the big guns mostly ignore them, these types of stocks offer the best, outsized opportunities for growth.
I screened for stocks under $3 billion in market cap and offering earnings surprises of 15% or more in the previous quarter, with long-term earnings growth forecasted to be at least 15%. One stock that floated to the top was gadget accessories maker ZAGG (NASDAQ:ZAGG), best known for its smartphone screen protectors and tablet keyboards for Apple (NASDAQ:AAPL) and Android products. It saw earnings jump 44% ahead of Zack's analyst expectations even as it still expect its earnings to grow 24% annually for the next five years. With a $206 million market cap, it easily makes it into our range for potential investment candidates.
Of course, don't jump on a stock just for those reasons. It should just be a starting point for more research as we need to look more closely to see whether analysts' faith in them is well-founded.
It's a matter of trust
It's not enough that a company is able to beat analyst earnings expectations, as ZAGG has proved time and again it is able to do, but it must provide investors with a level of trust that it can also run its business ethically, and thus far its executives and board of directors have failed to do so.
The seamy side of its business decisions came out in a Friday night press release dump, where it announced the immediate resignation of its CEO, who had unloaded more than half a million company shares on the market to meet a margin call. Actually, ZAGG never said why Robert Pedersen was resigning; it was left up to intrepid investors to suss out from his own SEC report that it was due to having pledged his company stock and was now being called on it.
Oh, about that margin call ...
During a subsequent conference call, ZAGG did admit the resignation was due to the margin call situation but also noted the wheels were set in motion last December, when Pedersen sold 345,000 shares, which at the time was simply described as his having to meet an "immediate financial obligation." While that was the excuse used then, ZAGG eventually admitted it was actually due to a margin call. So ZAGG obfuscated this entire episode and hid the fact that Pedersen had an additional million shares pledged as collateral. Since it filed proxy forms with the SEC that completely ignored this development -- something it's required to do -- it seems there may be regulatory problems that arise from that omission.
Did we forget to mention this, too?
What may also have come as a surprise to investors was that the board had hired his successor, Randy Hale, at the same time as the margin calls began and surreptitiously plotted a course of removing Pedersen as CEO and replacing him with Hale. Day-to-day operations were turned over to Hale, unbeknownst to investors, soon after he assumed the role of president. Once Pedersen sold all of his remaining company stock and stepped down, the board put in place restrictions on letting executives do so in the future.
This is something companies need to get out in front of proactively. Green Mountain Coffee Roasters (NASDAQ:GMCR.DL), for example, stripped its Chairman Robert Stiller of his title after one of his stock sales ran afoul of company policies. On the other hand, Chesapeake Energy (OTC:CHKA.Q) faced harsh criticism after CEO Aubrey McClendon had a serious run-in with margin calls yet faced no serious rebuke from the company's board.
Now that ZAGG's shenanigans have come to light, the stock has lost nearly half its value since hitting over $13 a share back in late April. It trades at less than seven times those generous earnings estimates, but without confidence in its management team, that seems less impressive than it otherwise would.
I was wrong, you were right
In the past, I was critical of the way inventories were piling up at ZAGG and was swayed that its distribution system, along with the launch of the latest iterations of the iPad and iPhone, would sell off those inventories. I should've maintained my skepticism, because I closed out my underperform rating on the stock on Motley Fool CAPS and initiated an outperform rating -- right before the troubles began! The 180,000 member-driven investor community translates informed opinion into stock ratings of one to five stars.
ZAGG, with a one-star rating, has lost 32% of its value since I zigzagged with my opinion, compared with a 2% loss on the S&P 500. I've since closed out my rating and gone back to my previous skepticism.
The fact is, as I had previously noted in my more bearish days, ZAGG's protective coverings are really a highly commoditized product, with competition from Best Buy's (NYSE:BBY) Rocketfish division and Logitech (NASDAQ:LOGI). Gorilla Glass from Corning (NYSE:GLW) almost makes the protective coverings superfluous, and upstart GT Advanced Technologies (NASDAQ: GTAT) is introducing an even stronger, more durable sapphire substrate to the market. With a cash conversion cycle that's out of control, there's little reason to think whatever earnings surprises ZAGG's previously enjoyed, it'll eventually come to and end.
But you can tell me in the comments section below whether you think ZAGG is a bargain at this price or if it's left without any protection. I think it ultimately gets bought out by someone, but not till after its legal mess is behind it and for a much lower valuation.
Editor’s Note: A previous version of this article incorrectly stated Green Mountain’s CEO, not Chairman, pledged company stock. This has been corrected, and the Fool regrets the error.