If you're looking for companies with plenty of room to grow, the market for small-cap stocks is a great place to start. The definition of small cap can vary from source to source, but the market capitalization line is generally drawn no higher than $4 billion. Investments that fall in this range can offer more growth potential than large-cap stocks, but there are risks as well.
The volatility that typically comes with these investments can work against you, so it's advisable to do your research and weigh potential risks and rewards before making picks. To put investors on the trail of some compelling small-cap stocks, we asked three Motley Fool contributors to profile a small-cap company that could turn into a big winner. Read on to learn why American Eagle Outfitters (AEO -3.10%), Sonic Corp. (SONC), and Habit Restaurants (HABT) made the list.
Sean Williams (American Eagle Outfitters): I've always been a big supporter of small-cap companies, because sometimes the best values can be found among Wall Street's forgotten companies. One consumer goods company that piques my interest is mall-based teen-apparel retailer American Eagle Outfitters.
There's little denying that teen-apparel retailers have had a tough run over the past two years. Beginning with a weak back-to-school quarter in 2013 and exacerbated by tougher competition from department stores during the 2013 and 2014 holiday seasons, American Eagle, Abercrombie & Fitch (ANF -2.12%), and Aeropostale (AROPQ) all tucked their tail between their legs and hoped for the best.
However, American Eagle Outfitters, or AE, has been on fire recently, in keeping with its habit of seeming to historically be the quickest teen-clothing retailer to dig itself out of tough times.
American Eagle Outfitters has a number of advantages that I suspect could drive its share price higher over the next five years. First, it sells branded merchandise. Teens love branded apparel that helps identify them with a particular genre and unites them with their friends and sometimes complete strangers.
American Eagle also has just the right balance of price and brand quality. While Abercrombie's prices might scare away the typical American household, and Aeropostale's deep discount sales cheapen its brand image, AE's median price point gives teens and their parents access to branded merchandise at a reasonable cost. The company's focus on its direct-to-consumer business has also been a big boon that has allowed for easier competitor comparisons that put AE's price and quality balance in the forefront.
American Eagle has also been quick to respond to inventory gluts throughout its history, regardless of which CEO has been at the helm. Correctly predicting which fashion trends will dominate isn't always possible in the teen market, so it's good to know AE's management team can shift its strategy quickly and efficiently when needed.
Lastly, take solace in AE's substantial cash and cash equivalent balance of $327 million at the end of the first quarter, with no debt. It shows AE is committed to expanding using only its cash on hand and positive operating cash flow, and it also acts as a nice backdrop for the company's above-average 3% dividend yield.
Bob Ciura (Sonic): Sonic has just a $1.5 billion market capitalization, which is far below the leaders in the fast-food industry, but the company is a small-cap consumer stock that has significant potential for big returns. Sonic is at a much earlier stage of its growth, with most of its locations concentrated in select regions, especially in the South. Sonic only operates approximately 3,500 restaurants, so there's plenty of room for further growth.
So far, Sonic's performance is truly impressive. Earnings per share doubled last quarter, and thanks to stronger customer traffic, same-restaurant sales jumped 11% in the same period. Perhaps the biggest reason for this is the unique Sonic customer experience, which separates it from the fast-food pack. Along with being the largest drive-in chain in the United States, Sonic offers a large number of desserts, including its Master Blast ice cream treats, which help to drive traffic.
Fortunately for shareholders, Sonic is returning a large amount of its cash flow to investors. The company has reduced its shares outstanding by 23% since it initiated its current share buyback program three years ago. Sonic also recently started paying a decent, but not huge dividend, with a 1.3% yield. As revenue and earnings continue to grow, however, the payout is likely to grow, too.
Keith Noonan (Habit Restaurants): There has been no shortage of fast-casual chains going public over the last five years, but Habit Restaurants stands out from the crowd. The hamburger slinger delivered 12% same-store sales growth in its last quarter, along with 44% revenue growth to $54.6 million. Habit has posted same-store sales growth for 45 consecutive quarters. The company has a market cap of roughly $900 million and expects sales between $221 million and $225 million in the current fiscal year. Habit also has big expansion potential down the line.
The company has just 125 locations across six American states, with the bulk of its restaurants located in California. It topped Consumer Reports' 2014 Best Burger list, which suggests there will be plenty of appetite for the company's food as it spreads across the country. The trend of fast-casual chains taking market share from more established fast-food eateries looks set to continue, and offering relatively inexpensive fare compared to burger rivals such as Shake Shack and Five Guys could also help Habit bridge the demographic gap and provide insulation in the event of economic downturn.
Habit's stock is up roughly 93% from its December 2014 IPO and priced for long-term growth, but the company looks like it can serve up impressive wins.