5 Smaller, Low-Risk Rule Breaker Stock Picks From David Gardner

While business headlines usually focus on the corporate giants and the hottest tech enterprises on the market, there are a plethora of smaller, quieter companies with fantastic growth opportunities stretching in front of them.

In this episode of the Rule Breaker Investing podcast, David Gardner shares five of his favorite smaller, lower-risk stock picks. These companies have ample room to grow, and while economic downturns like the one we're in now tend to hit them hard, long-term investors know they'll be back -- and likely much stronger than before.

Tune in to hear what about each of the five makes them so appropriate for Rule Breakers, and what red flags investors need to be aware of.

A full transcript follows the video.

This podcast was recorded on Feb. 10, 2016. 

David Gardner: But what I was specifically looking for are very low-risk companies -- that's attribute No. 1. These are typically -- for those who know our risk rating system, the lower the number, the lower the risk -- these are around 5 or 6, most of the stocks that I'll be mentioning. 

But then the other thing I was looking for are companies that are smaller. Not great big companies like Apple, [Amazon.com], Disney (NYSE: DIS). By the way, all three of those companies are down 20% in the last three months -- in excess of 20%. So if you're wondering how bad have things been, that's pretty bad for the market. If you're thinking this is just going to continue, I doubt it. So these are not the Apples, Amazons, and Disneys, because those are companies with very large market capitalizations, usually 12 figures, $100 billion-plus. I'm looking at companies that are more in the $1 billion-$5 billion range. And why do I like these companies right now? These are the stocks that tend to bounce back stronger, usually. They snap back higher because they've taken a bigger hit than the big companies, usually. They're more volatile, they're smaller, but since I'm really not even thinking about bounce backs, I'm thinking about three-plus years, I like these stocks anyway. So I think they have, as lighter-weight companies, an opportunity to go higher than some of those other companies I just mentioned.

So those are the two attributes. Again: lower-risk companies that are smaller. And here come my five, in no particular order. For each of these, I'll be mentioning a general investing principle that underlies this pick as well. I'm going to talk about a few things I like about the company, and then I'll add one note of caution for each of these as well, just to round things out.

First up this week is Carter's (CRI 0.48%). Now, you may know Carter's. You may know their OshKosh B'gosh, I think I said that right, brand. I certainly see it in the stores. This is a company that's been around for decades, and is really a leader in something that's never going to change: that is, cute clothes for babies, for little kids, for toddlers. So this is a branded long-term leader in the space, but also a company that is experiencing rapid growth in e-commerce, because you can go and buy clothes directly from them online. So they're participating there. They're not threatened by e-commerce, they're part of the revolution. They're also expanding internationally. So decades after their founding, they're just starting to make real incursions into China. And, you probably know, China has babies. That happens in China, there are a lot of babies. In fact, it's nice to know that if you're a Chinese citizen today, you can actually have more than one child for the first time in quite a while, which is very promising. 

Anyway, Carter's, this is the business. Perhaps you're a customer. But a company with share buybacks, dividends, and just an impressive company overall. Let me mention: This company has a risk rating of 5. And the stock was recently -- when I did this podcast -- at about $86 per share. This is a company worth about $4.5 billion today. 

I want to mention, for each of these, how I've done with the picks so far. You might be interested. So, we first picked this in Motley Fool Stock Advisor in April of 2014. So here we are just about two years later, the stock's up 18%. Not bad. Hasn't lit the world on fire, but the S&P 500, by comparison, is up 3%. So this company is beating the market by about 15 percentage points so far. And I like it a lot for the long term.

One note for caution for each of these. For this one: the strong dollar, which is true today -- the American dollar has appreciated dramatically against many worldwide currencies. The U.S. economy is kind of a safe haven. And that hurts companies like, in this case, Carter's, when they're trying to sell their produce abroad. So their manufactured goods, in this case, their apparel, their threads, just have a higher price tag if you're looking at them in China today than they would have a few years ago. So that dampens some of their international growth possibilities in the near term. But this is a cautionary note that is not a long-term cautionary note, it's just something about the here and now.

And then, my closing general investing principle that Carter's, I think, highlights for us as investors: I love businesses that deliver over decades. That please consumers, particularly. Companies that can create consumer brands over multiple generations. That's not easy to do. And further, this is a lesser-known company. You probably were expecting me to lead off Rule Breaker Investing with my favorite tech stock, whatever that phrase means. But my favorite tech stock? No. Actually, I'm leading off with Carter's. And one thing I like about Carter's is, it is lesser-known. It's not something you'd expect, maybe, from Rule Breaker Investing or for your friend at the water cooler to be talking about. But these are the kinds of companies that really do return well for us as investors over long periods of time.

Stock No. 2 this week. Stock No. 2 is IPG Photonics (IPGP -0.38%). IPG Photonics recently traded at about $83 per share, and it's worth about the same amount as Carter's, $4.4 billion, in this case. It has a risk rating of 6. Low-risk company. Now, IPG Photonics -- legacy lasers are going out, and fiber lasers are coming in. This is a trend that's been going on quite a while. Fiber lasers -- and by the way, I am not an engineer here, so I'm bringing out my best English major explanation for you. Fiber lasers are basically better technology that is more cost-effective. So it's a nice, disruptive combination of more affordable, cheaper prices and superior technology. And in fact, since the CEO founded this company in 1990 -- his name is Valentin Gapontsev -- he's been a brilliant manager. One of the best unknown CEOs in America. So here he is, 26 years later at the helm of this company that took the technology that he brought to our country from his native country of Russia, and has created a great, entrepreneurial enterprise based in Massachusetts today. 

But IPG Photonics, just to give you a little bit about where we picked this stock and how long we've been following it, I first picked it in April of 2007 at $20.53, so pretty happy it's around $83 today, even if it's down from its recent highs. It's up about 250%. But importantly for this one, a year later, in March of 2008, it had dropped from $20 to about $13, and we recommended it again. I'm foreshadowing our general investing principle with this one, which I'll cover in a second. But that position is up about 5 times in value since then, and of course, both are well ahead of the market.

Now, this technology is very relevant. It spans many different industries. We're talking about the medical industry, telecom. If you are a movie theater owner, and you want a more beautiful picture, you're probably looking at IPG's laser technology. Lithium-ion battery systems for electric cars. There's a lot of laser welding that's making those battery systems, those lithium-ion battery systems possible. So this is a company with not just one customer, but lots of different applications across multiple industries, which I like a lot. And finally, like I already mentioned, I like the CEO a lot. He's been around for a long time, owned some stock, and he's created a great company.

A note of caution about IPG Photonics: You may have heard, China's slowing down. China is a meaningful market for this company. So this company, like some others, gets dinged when we hear the slowdown in China affecting global business. That's something you have to know about IPG Photonics. 

That's stock No. 2. My general investing principle: Buying good companies right into the teeth of bear markets is rewarding. I hope that sounds good to you this particular week, as we find ourselves in mid-February of 2016. A lot of us looking -- I'm wearing a big red sweater today, for those who might be watching the video of this podcast on Yahoo! Finance, you'll see me in a great big red sweater because my stocks are well down in the last few months. I think, my own portfolio, I'm down, I think, more than 25% last time I looked, which is not a very nice two months for anybody's portfolio. But I say that with a smile on my face, because it's happened before, and it'll happen again in the future. And, in particular, as I talk about these companies this week, I'm feeling really good about their prospects 3-plus years going forward. And IPG is no exception. I love being able to point back to 2008, where we watched our stock pick go from $20 to $13, and we said we're buying. And that position is really up over the last seven or right years. So that's what I'm thinking about, this stock in another seven to eight years. We'll see.

Stock No. 3 this week. Stock No. 3 is Ellie Mae (ELLI). Ellie Mae, the ticker symbol is ELLI, it is on the Nasdaq. By the way, I haven't been giving ticker symbols, but you can look it up online. Use Fool.com to find your ticker symbols if you need these. The stock was recently at $60 per share. This company's smaller than the first two I covered. It's about $1.8 billion, its market cap. Its risk rating, right in there at 6. Again, each of these, 5 or 6, these are very low-risk investments. We define risk, by the way, as the chance that you will permanently lose a fair amount of your capital if you own the stock for the long term. That's what risk is for me. That's what we're trying to avoid. So we think that's much less likely to happen in these companies that I'm mentioning this week than some of the others, some of our biotechs or others that are certainly higher-risk, sometimes higher-reward, too.

Ellie Mae is a software company, it processes mortgage applications. In fact, the company has about 25% of the market share of the U.S. So this is a company that is using the software-as-a-service model, connecting mortgage professionals with lenders and service providers, and this is a good example of a growth market that's very quiet. Very few people have heard of Ellie Mae. However, if you're in the mortgage industry, I'm pretty sure you have. You may well be using the company's platform.

We first brought this stock to Rule Breakers in October of 2012. It's done quite well, up 137% since then. The S&P 500 up 41%. So this has been a quiet double and a strong performer, a company that has good growth and took a real hit recently when -- it was, in fact, Feb. 5, just days ago. It dropped 11% or so in one day not on its news, but simply on the enterprise software industry selling off. You may have seen Tableau, which is certainly a leader in that industry, gave some pretty bearish projections about its business in the next few years. So Tableau watched its market cap get shaved in half that day. So a company like Ellie Mae sold off 11% not on its news, but in sympathy with the rest of its so-called "industry."

But what I want to point out here, and here's our general investing principle: I really like the so-called "pick and shovel" companies, when they're working in industries that I think are going to be around a long time. So you know the whole thing about picks and shovels? You probably do. The idea was, the only people who made money during the gold rush back in 1849 weren't those that went out to California hoping to strike it rich finding gold, but rather the companies that were selling the picks and the shovels to go ahead and search for gold. So that's the way I think of a company like Ellie Mae. This is not a play on the housing market, per se. I'm not making any comments about the strength or not of mortgages right now, or, specifically, mortgage lending. This is not something that I spend a lot of time at personally. I'm not an expert on housing or real estate. I like software companies. That's what Ellie Mae is. It's a software company, a pick-and-shovel company, and usually, the ones off the beaten path are good for long-term returns.

Now, a note of caution: This company is pretty opaque. Part of being a pick-and-shovel company is that you and I have a harder time figuring out how that business is doing. So when you own a stock like this, and I have it in my portfolio, I'll usually be surprised if there's bad news. I feel like you and I can see when bad news is hitting Chipotle, because it hits national headlines. But we have less of a shot of doing that at these more opaque business-to-business companies. So that's something you have to bear in mind as a point of caution around Ellie Mae.

Are we through three already? All right. Stock No. 4. Stock No. 4 this week is Planet Fitness (PLNT 0.05%). Planet Fitness is trading recently at about $14 a share. The market cap? Kind of the same size as Ellie Mae, a smaller company. It's $1.4 billion. This is one of our most recent picks, so this is a pretty fresh pick coming from our Motley Fool Rule Breakers service. In fact, it was the end of January when we purchased it. I'm happy to say, yes, I can even say this, not about many stocks, but it is up. It is up since we purchased it, [laughs] recommending it on Jan. 27. The market is down; lots of our stocks are down. 

Planet Fitness, you may have seen their marketing, "No Lunks." I like this business. It is a membership subscription business, and it is hitting the mass market for people who want to work out. Not people who really work out, not those other people, but people, maybe, more like me. I might include you with me here. But those of us who want a simpler, cheaper, lower-key approach to staying fit. So Planet Fitness, for example, has a $10 initiation fee. Try that at your local gym. See what it takes to just get started for that membership. Usually, you're paying more than $10. In fact, Planet Fitness throws in a T-shirt for you for your $10 initiation fee. And then, speaking of cheaper fees, $10 a month. Check that out against any competition you see in your local area. I submit it is going to be much cheaper. But this is a company that is making money from those price points by being disruptive. No frills.

Now, it does mean you don't get a lot of stuff at Planet Fitness. You're not going to get day care. There are no juice bars. There are no fitness classes, that I know of, anyway, at Planet Fitness. No racquetball courts or swimming pools. They're just keeping it simple, with treadmills and workout gear, and creating a well-lit, friendly space that people can return to and not feel like they have to impress others with the shape of their body or how strenuously they're working out. "No Lunks," as Planet Fitness says.

This is a business that has more than 6 million members, and my general investing principle that I want to highlight for this one, stock No. 4, is that I love subscription businesses. In fact, we have one at The Motley Fool. It's a model that I like a lot. If you do a good job by your customers, not only have they purchased from you, but they will then renew their subscription with you if you do a good job. If you don't, if you make bad stock picks or have broken treadmills, then people will not. They won't come back the next month or next year. But it's a wonderful business model because it replaces its revenue in a much more reliable way than many other businesses that have to keep going out there and scrabbling around to get growth. So, that's a happy dynamic we have here at The Motley Fool, and, certainly, Planet Fitness, a much larger company than The Motley Fool, is one example. But whether you're talking about Netflix or AOL, back in the day, or any number of these kinds of regular subscription business models, I favor them greatly. They're usually very numerical, they're very predictable, and it really focuses, the company that's doing it, on making sure its customers are pleased, that there's satisfaction, and they want to renew for one month or year to the next.

So, that's Planet Fitness. Now, my one cautionary note about PLNT on the Nasdaq, this is a company, first of all, that we don't know quite as well compared to the other companies I've talked about. We usually have multi-year associations. These are long-term investments, and I'm letting you in on them and saying I like them today, I especially like them watching what the market has gone to some of these. But we have less association with Planet Fitness, so I don't know it as well as some of the others that I'm talking about. 

And I'd like to mention in particular a cautionary note about its low-fee business. So, typically, I favor companies are more of the premium brands in their industries. Those are usually the companies that have pricing power, that can raise prices. People don't really notice if, with Tiffany, if the diamond is a little bit more next year than it was this year. It's Tiffany. When Netflix raises prices -- it is in the process of doing so, modestly. I think it's an incredibly great deal, what I'm paying Netflix for streaming monthly right now. But Netflix has that ability, I think, to raise prices over time. Planet Fitness has really predicated a lot of its business on the idea that it is the low-cost provider and low-cost player. That's not often as comfortable a place for me to feel confident in my investing. But, that said, when you have a disruptor, and somebody who has fun with their marketing, and I think really appeals to the broadest group, those of us who don't work out intensely everyday but still think it's a good thing, of course I favor this company.

And finally, this week's stock No. 5. Stock No. 5 is MercadoLibre (MELI -1.01%). MercadoLibre has a risk rating of 5, right in line with the others. It is right in between the sizes of the four that we've already covered. It's about $3.5 billion today. The stock's at $87 as I do this podcast. And this is the Latin American e-commerce giant. This is a company that we've followed for quite a long time. In fact, my first recommendation of it was in February of 2009. So that is seven years ago this month. The stock was at $14.22 when we recommended it. Today, it's $87, so that's not been a bad investment at all. 

But here's something that's surprised me. I've re-recommended it twice in Motley Fool Rule Breakers since, and it's actually losing to the market from those positions starting in 2012, one of them, and then another in 2014. It's substantially down from where it was in 2014. So, in fact, speaking of substantially down, this is a stock whose 52-week high is $153 and presently, as I mentioned, is trading at around $87.

So this is a company we like a lot for the long term. They have excellent management. I like their positioning as the leader in Latin America in e-commerce. It's a fully featured business, it can do the eBay-like part of e-commerce with auctions. In fact, speaking of eBay, PayPal is such a big part of eBay's success. MercadoLibre has MercadoPago, which is also a payment system that MercadoLibre runs. And it also fulfils like Amazon does. So for many countries in South and Central America, it is the e-commerce leader. And of course, I like that area of the world. Really, I like almost all areas of the world, frankly, going forward multiple decades. I'm a real bull on global business. And I see MercadoLibre, with its ... I won't say stranglehold, but I'll say dominant position over a meaningful portion of the globe that's still early on in its acceptance and adoption of capitalism. 

In fact, my cautionary note about MercadoLibre, I'll sound right now, some of its businesses are run in Venezuela, Argentina. If you're somebody who pays attention to business, you recognize these as countries that don't really respect entrepreneurship and that tend to sometimes tend to just co-opt businesses all together and say, "That's now owned by the government. Sorry, American oil company that had developed that field." These are countries that I would not want to do business in, personally. And MercadoLibre is doing business in them. And, I think, over time, they will improve, and MercadoLibre will be part of that story. But it is, in the near term, certainly a difficult business environment, sometimes, when you have to work in some of these countries. Some large countries. Fortunately, others like Brazil and Peru and Colombia and other countries that are really awakening, I think, to more prosperity for their citizens and more respect for human nature and our way of life. Those are all part of MercadoLibre's story today. So we like this company a lot.

And my general investing principle, as I close it up here this week for MercadoLibre: I like to look at replacement cost. Let me quickly define my term. If you ask yourself, what would it cost you if you and I wanted to go into business today, and we snapped our fingers and were able to make MercadoLibre disappear? We snap our fingers, whoosh, it's gone. How much would it cost you and I, how much money would we have to raise, how much effort would it take to replace what MercadoLibre is doing today? And usually, while there's no round number that I ever put to it, I just ask myself, what is really expensive and hard to replace? And I believe MercadoLibre, what it has achieved, is extremely expensive and hard to replace. So when I see the company worth less than $4 billion today, and I ask myself, what's the value of being where it is, playing for the next few decades, in terms of the profits it has coming to it, I see a very high replacement cost. So it's going to be hard for anybody else to come in and really compete in the same way that, in our country, and other countries, too, Amazon.com is a pretty hard competitor for a lot. The replacement cost is very high for Amazon.com. So that's my general investing principle applied to MercadoLibre.