A Small Cap for Any Market

Cash will never be king of the portfolio, but it's looking princely these days. The tepid, hesitant market seems to reflect a little Iraq worry, some concern over the economy, and a lot of general uncertainty about itself. If you read much investing news, you know that many professional managers -- not to mention individual investors -- are sitting on more cash than usual. Even Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) Warren Buffett has been holding extra greenbacks lately.

To be sure, holding cash beats losing money. Bonds look bleak. And large caps and fashionable stocks may get punished if the market decides to reinvent itself on a valuation level again.

So what's an investor to do?

The time may be right to scout for stocks a bit out of the ordinary -- those that seem to ride a different wave from much of the market.

I've been looking for a small cap with moderate growth potential, safety, and an offbeat nature. Time may prove me wrong, but I might have found one in Watsco (NYSE:WSO), a middleman for HVAC (heating, ventilation, and air conditioning) systems and parts with a $660 million market cap.

"Mama, when I grow up I want to marry..."
... into the HVAC distribution business. Maybe not. But if you're thinking white vans and gratuitous backside visibility, think again. The distribution end alone is a $20 billion buffet table, which Watsco -- currently the largest player with 6% of that market -- has been chomping into via organic growth and acquisitions.

You've heard it said that acquisitions usually don't work out. (Or at least now you have.) While that's generally true -- be especially cautious of acquisitions into unrelated industries -- some companies seem to do it with style. And profit.

Let me buy your privates
Watsco is not a hog-wild acquirer. It goes for well-established regional players that tend to lead their markets. Moreover, these companies -- Watsco picks up a few every year -- are privately held, which helps keep buyout prices out of the stratosphere. In fact, that's part of the reason that an acquisition strategy works so well for them.

The other part is that Watsco knows how to get the best out of these companies once they're on board. Ironically, it does this by doing very little. The company names as well as management teams stay in place, which leaves the previous owners a bit happier -- offsetting some of the emotional concerns they might have over selling the family business -- and keeps everything constant with the installers on the front line who buy HVAC appliances and related parts from Watsco (their revenue, like the industry's, is split about 50/50 between appliances and parts) before reselling them to home and business owners.

A warm wind that's safe to inhale
One thing that doesn't stay constant is the collective ability to buy in bulk and leverage resultant efficiencies, a main reason that Watsco is, and should continue to be, increasingly dominant in this moderate-growth industry. It's hard to go wrong buying the heavy hitter; Watsco's revenues are quadruple those of its next-largest competitor. And the fact that it sells to almost 40,000 contractors, rather than such muscle-bound buyers as HomeDepot (NYSE:HD) or Lowe's (NYSE:LOW), keeps buyer power down, too.

But back to efficiency, which is increasing for Watsco just as it is for the A/C units it distributes. For starters, the cash-to-cash cycle, a standard yardstick of operations that tallies the days between a company's cash outlay (to suppliers such as Carrier (NYSE:UTX)) and its eventual cash collection (from customers), has been shrinking nicely:

Next up is return on equity, a measure describing net income as a percentage of a company's book value. A higher ROE means a company is earning more with what it's got, and Watsco has been:

*Trailing 12 months

The granddaddy of measures (or metrics, if you want to sound in-the-know) for any company's effectiveness is return on invested capital. At least in concept, ROIC is simple: It represents the after-taxes-and-expenses earnings a company has available to cover its costs of financing. The cost of debt -- which constitutes less than 10% of Watsco's financing -- is simple to understand.

Tougher to estimate (academic careers could be spent on its study) is the implied cost of equity financing, or the returns that current shareholders are expecting from the stock. Anyhow, the higher the ROIC, the better, because a company's raison d'etre is to take financing from given sources and generate returns that exceed the overall cost of that financing. It's a bit like getting a loan from the bank to make some investments. Whatever you do, you'd better earn at least the interest rate the bank wants in order to make the whole thing worthwhile. In the corporate world, a company's investments are basically its operations.

I won't get into a numerical cost of equity for Watsco, because I think a guesstimate is accurate enough for our purposes (although you can get more detailed small-cap analysis through our Hidden Gems newsletter). You see, there's not a ton of elasticity in its business: You're not going to wait until the economy improves to fix a broken A/C or heater. This stability means that while its investors would certainly enjoy high returns, they'd be willing to accept returns lower than they'd demand from a higher-risk stock on account of Watsco's stability. My guess for an implied cost of equity is 7%-9%.

Watsco's corresponding ROICs are on the upper end of that range (a good thing). Moreover, they're improving (a really good thing):

*Trailing 12 months

Of course, nobody's perfect. Worth mentioning is that CEO Al Nahmad controls about 60% of voting shares. His 31 years at the company vouch that he's in it for the long haul, and I'm not aware of any issues arising out of his heavy holdings to date.

Since HVAC is a mature industry, though, my greatest worry is long-term revenue growth. Watsco hopes to better the 4.5% annual revenue growth the industry has had over the past 15 years. But all this sub-10% growth is low by small-cap standards.

With growth being only a modest flame on one end of the candle, margin improvement takes a more prominent role in value creation than usual for a small cap. Fortunately, Watsco is up to the task, as its growth has allowed it to become a better operator. Though I might be stretching it a bit, the company's growing clout seems to be turning it into the Wal-Mart (NYSE:WMT) of the HVAC distribution business -- a company that seems easy enough to spoof but in the end it turns out to be so much bigger and better that its peers can't catch up.

Investors have caught something, though: a growing dividend. The quarterly $0.10 per share adds up to a current 1.39% dividend yield -- far from qualifying as a dividend heavyweight for Mathew Emmert's Income Investor newsletter. But, hey, take what you can get. It's great that management has opened the gates on dividends -- they will likely grow steadily in the future.

And steady growth, regardless of the market, is really what Watsco is all about. Unlike for many small caps, there is no event in its future. No patent approval, no "going live." No slew of unsustainable investor expectations to accompany that event. In fact, I believe Watsco is relatively unnoticed in spite of the returns its stock has enjoyed over the past few years.

Of course, an HVAC distribution company will never be famous, but it doesn't take a famous stock to add strong returns to your portfolio. It does take more than cash, though. In this market, giving up a little growth in exchange for stable returns somewhat insulated from the market might be one of the best trades going.

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James Earlyis holding cash right now -- $26 in his wallet, to be exact. He owns no stocks mentioned in this article. The Motley Fool is investors writing for investors.