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 | |
|---|---|---|---|---|---|---|
| 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
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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.
