Many small-cap investors hate volatility because it gives them a hollow feeling in their gut -- when one of their positions sheds a cool 40% on no news, for instance. I used to hate volatility because I couldn't stand seeing red on my scorecard. But now I embrace it. Thanks to that very same small-cap volatility, those dips are potential opportunities to add to equity positions and gain handsomely over the long term. As master investor Warren Buffett said recently, a net buyer in any market should prefer to see prices fall -- be it supermarket produce or stocks -- in order to get the most out of your money.
Volatility is everywhere
Since 1990, Harley-Davidson (NYSE:HDI) has grown from a $700 million niche retailer into a $14 billion phenomenon. Investors who bought early have been rewarded with market-crushing 22% compounded annual growth -- but it wasn't a smooth ride. Harley took one-month dives of 20% or more on 13 separate occasions during that run, including one last April. Those drops never spelled disaster, but served as opportunities for savvy investors to build out a position and realize even greater long-term gains.
You can see the same phenomenal opportunities in the stock charts of other long-term market-beaters. Gillette (NYSE:G) dropped more than 25% in 2002, but has since almost doubled. Home Depot (NYSE:HD) shed more than 50% of its value from 2002 to 2003, but has since returned that money to investors. The same happened to Staples (NASDAQ:SPLS) in 2002. The company suffered a dire 50% haircut, only to rise again.
Safety in safety equipment
Mine Safety Appliances (NYSE:MSA) has quietly been one of the best performers in the Motley Fool Hidden Gems portfolio, sporting a 150% gain since it was recommended in September 2003. But just as savvy investors found excellent entry points along Harley-Davidson's journey, so have those of us who own Mine Safety -- including a short dip to $26 in May 2004. By adding to my position at that time, I earned an additional 50% gain in a little over a year.
But let me be clear: Not every drop is a buying opportunity. The key is to recognize when the market has dumped on a superior company for no good reason at all.
Crack the code
Mine Safety has already experienced two precipitous drops this year -- 26% in March before recovering and 20% at the beginning of this month, from which it has yet to recover. Is now a good time to build out a position?
When your favorite stock drops, it's important to breathe deep and examine the hard numbers. Here's Mine Safety's annual growth performance:
| Sales | Free Cash Flow | Gross Margins | SG&A | Receivables | Inventories | |
|---|---|---|---|---|---|---|
| 2005* | 9.95% | 23.18% | 40.34% | 23.80% | 7.13% | 23.31% |
| 2004 | 22.40% | 31.82% | 39.93% | 24.02% | 24.39% | 38.56% |
| 2003 | 23.39% | 43.73% | 39.37% | 25.85% | 38.04% | 17.40% |
| 2002 | 10.73% | 6.71% | 38.90% | 26.53% | 5.70% | -1.45% |
Cash flow numbers have been excellent. Margins are improving, costs are decreasing, and top-line growth has been steady. The balance sheet is not as rosy -- both receivables and inventories are increasing faster than sales.
Management has addressed the receivables problem in the past year. There is a new focus to reduce days sales outstanding, a measure of how long it takes the company to collect on sales. Unfortunately, there has been no clear long-term solution proposed for inventories. First-half revenue growth has also slowed, although this can be attributed to delayed government funding and capacity issues with a supplier. Although management believes these revenues will recover in the second half of the year, I remain skeptical.
To reflect my skepticism, I'm valuing the stock using 15% bottom-line growth over the next few years -- much less than the company has demonstrated recently. With that assumption, I value shares at $42 per stub using a 12% discount rate. In other words, this slide isn't a buying opportunity; rather, it's a regression to fair value. That said, investors who were savvy enough to snap up shares last April for $35 got a pretty good deal.
Foolish final thoughts
Outwitting the traders isn't as simple as buying small caps on dips. It's important to constantly value your small cap to know which dips are worth it and which dips are not. At Motley Fool Hidden Gems, analysts Tom Gardner and Bill Mann keep subscribers constantly updated on all 48 active recommendations. Hidden Gems recommendations are already beating the market by 20 percentage points. If you're interested in finding out which small caps they like and interacting with thousands of investors who are actively following these companies, click here to take a risk-free 30-day trial. You have no obligation to subscribe.
Although Mine Safety is worth passing on right now, like all good small caps, the stock will drop again -- and we'll be waiting with our valuation.
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Jason Neilson owns shares of Mine Safety, but no other companies mentioned. Home Depot is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.
