Three Small-Caps That Pass the Value Test

• ByTim Melvin, RealMoney.com Contributor
• On 1:15 pm EDT, Thursday October 29, 2009

When I shuffled out to the mailbox yesterday, I found that the new edition of Forbes was in. The issue contains the new list of the 200 best small companies. The magazine rates them on sales and earnings growth as well as return on equity. It ranks the figures on both 12-month and five-year bases to find those companies that appear to be experiencing sustained growth and are not one-hit wonders. The resulting list is composed of companies that are taking advantage of business and economic trends far better than their larger competitors and are growing very rapidly.

Although the list is very good at finding underlying trends in the marketplace, it is not usually a good place for me to find investment ideas. Since the companies are by nature growth stocks, this is usually reflected in their share price. Even if a company is in front of major parts of the stimulus packages or manufacturing critical components for wireless technology, I always focus on valuation first and foremost.

Quality Systems, for example, is going to a major beneficiary of the $20 billion medical records legislation in last year's stimulus package. Its medical records management software package is one of the best out there. However, there is no way I could ever pay 37 times this year's earnings or 25 times the estimate. The value investor in me cringes at the enterprise-value-to-EBITDA multiple of 21.

Going through this year's list, however, I was surprised to find a few companies that do fit a value investor's approach. Because they are smaller companies, a lot of this year's best companies have not fully recovered from the global equities market selloff that occurred in 2007 and 2008. I was able to find some companies with price-to-book-value, price-to-earnings and EV-to-EBITDA ratios that are at least close to being a bargain.

One stock that is now on my radar list is, of all things, an airline. Unlike most airlines, however, this one had top- and bottom-line growth in its third-quarter earnings release.

Allegiant Travel flies to resort destinations such as Las Vegas, Orlando and Fort Lauderdale. It focuses on providing service from smaller cities usually, and it currently serves 61 cities. Also, unlike many airlines, it has a balance sheet that's rock-solid, with $224 million in cash and just $54 million of debt.

Allegiant is not as cheap as I would like on a book-value basis, but at less than 4 times enterprise-value-to-EBITDA and a P/E of just 8.6, it is cheap on earnings. That is very cheap, considering the company has grown revenue at 59% in the last five years and earnings at 37% over the same time period.

Sterling Construction is going to be right in the eye of the hurricane for infrastructure spending. It doesn't matter if the money comes from the current stimulus programs or from other sources after the economy finally recovers. America's roads, bridges and highways have to be rebuilt sooner rather than later.

Sterling is a construction company that specializes in roads, bridges, light rail as well as water infrastructure. Not only does the future look bright of this company, in the past five years revenue has grown by 25%, with earnings growth on average of 12% annually. Even with the growth and strong prospects, the company makes it on the numbers. The EV/EBITDA ratio is just 3.3, and the P/E is under 10. It trades at about 2 times tangible book, but on the basis of earnings and cash flow, the stock is cheap. The balance sheet is in pretty good shape as well, with more cash than long-term debt on the books.

American Physicians Service Group is another fast-growing company that is available at cheap prices right now. The company provides professional liability insurance for doctors and other medical professionals, primarily in Texas. It also offers a wide range of financial services including brokerage and investment advisory services. Over the past five years, its revenue and earnings have grown annually by 23% and 27% respectively.

The stock trades at just 1.2 times tangible book value and 8 times earnings. The enterprise-value-to-EBITDA ratio is just 4.46. The company's balance sheet is also strong, with almost two times more cash than debt on the balance sheet. The company has reported growth in both earnings and revenue through the first two quarters of this year, one of the few companies to do so.

It is not very often that I am able to find companies growing fast enough to make the Forbes list while also being cheap enough to pique my interest. These three are notable exceptions and are on my watch list.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider STRL and AMPH to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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