Traditional investing logic tells us that, when the economy turns sour like it has, we ought to flock to undervalued large-cap stocks because they not only have better access to capital than smaller companies do, but they also attract the smartest and brightest business minds.
If the recent market implosion has taught us anything, though, it's that a poorly run large company can fall harder than a poorly run small company in an unforgiving market. In fact, some small companies have adjusted much better than their larger counterparts.
Castles made of sand
Certainly there's still some merit in the conventional approach -- one could do far worse than buying quality names such as Microsoft
Yet there was no shortage of talent wanting to get in the doors of Lehman Brothers, Wachovia, and Bear Stearns -- in fact, all three employers were among the 100 "most desirable" MBA employers in 2008, according to a Fortune survey. If traditional logic held true, this high-caliber talent should have been able to recognize the firms' problems and correct them more quickly than a smaller company. As we all know, that reasoning failed many investors.
In fact, it's been a number of smaller financial firms -- like Great Southern Bancorp, a Midwestern bank with $3.4 billion in assets -- that have proven to be nimbler than Goliath-sized competitors like Bank of America
But it's not just the financials -- consistently poor execution at iconic American businesses like Xerox and Eastman Kodak has sent both stocks down to single digits, with few signs of them returning to their former glory. These companies employ tens of thousands and had plenty of access to capital, but simply failed to perform well over the years.
Now compare those giant tales of woe to the success of PetMed Express, a $335 million pet drug prescription company that employs about 250 people. In May, the company reported revenue growth of 17% year over year, remained free-cash-flow positive, and kept long-term debt off its balance sheet. Because of this, the company was able to fund itself through its own operations and had no need to beg (pun intended) for loans. As you might imagine, investors rewarded PetMed even in this merciless market -- shares are nearly 10% over the past year, while the S&P 500 is down over 30%.
Bucking the dividend trend
Another reason investors traditionally turned to large caps in this type of environment was for their consistent and reliable dividends, but after 62 S&P 500 companies cut their payouts in 2008 -- followed by another 62 so far in 2009, including Macy's, Alcoa
Indeed, in a conference call after the dividend cut, Macy's Chief Executive Terry J. Lundgren said, "We just believe that this is a time when nothing should be considered a sacred cow."
It's discouraging to see so many blue-chip companies that have paid or raised dividends for decades suddenly changing course and blaming their mistakes on the macroeconomic picture, but there are still companies out there -- large and small -- staying true to shareholders with dividend increases in this market.
One of those companies is $1.4 billion clothing retailer Buckle, which in November 2008 -- despite operating in the same consumer spending environment as the aforementioned Macy's -- paid its shareholders a special one-time $3-per-share dividend and increased the quarterly dividend by 20%. Buckle is able to do this because it isn't burdened by debt (it has no long-term debt whatsoever), and it generates plenty of free cash flow, giving it plenty of room to raise dividends or reinvest in the business for the benefit of its shareholders.
Choose your weapons wisely
In a market where economic agility and strong management matter more than ever, make sure you're studying well-run small companies alongside larger companies. For my money, I want to own companies, regardless of size, that have a strong management team, have a rock-solid balance sheet, and dominate their market niche.
One of the companies I've been researching recently is Darling International, a $550 million company that fills a niche not many others want to fill: collecting food service waste (i.e., grease and discarded meat) and rendering or recycling the waste into usable by-products like animal feed, industrial oils, and even biofuel.
It's not only the largest company in this field (and the only one that's publicly traded), but it also has contractual relationships with big names like McDonald's and SUPERVALU
If you're looking for more small-cap ideas for this market, our Motley Fool Hidden Gems team can help. Among other things, they look for stocks that are:
- Underfollowed on Wall Street.
- Led by dedicated founders.
- Financially strong.
- Dominant in their market niche.
A free 30-day trial of the Hidden Gems service is yours, so just click here to get started. There's no obligation to subscribe.
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This article was originally published March 20, 2009, and has been updated.
Todd Wenning is an equal-opportunity investor. He does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value selection. The Fool's disclosure policy is as fast as greased lightning.
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