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
You can see the same phenomenal opportunities in the stock charts of other long-term market-beaters. Gillette
Safety in safety equipment
Mine Safety Appliances
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|
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.
For more Foolishness, check out:
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.
More from The Motley Fool
What's the Best Age to Claim Social Security? It Depends on Your Health
The state of your health needs to be a driving factor in deciding when to take benefits. Here's why.
3 Fools, 1 Deep Dive Into the Disney/Fox Deal
Even for a media company as acquisitive as Disney, the assets it's picking up in this $52.4 billion purchase are major.
3 Dividend Stocks With Better Yields Than Johnson & Johnson
These stocks would serve your income portfolio better than Johnson & Johnson today.