Most investors shy away from small-cap stocks because they believe that they are risky. That's a shame, because small businesses tend to have more opportunities for growth ahead and can deliver huge returns for patient shareholders.
So which small-cap stocks do we think are great buys today? We asked a team of Motley Fool contributors to weigh in and they picked Employers Holdings (NYSE: EIG), KushCo Holdings (OTC: KSHB), and Proto Labs (NYSE: PRLB).
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A company whose product is mandatory for employers
Chuck Saletta (Employers Holdings): Most states require employers to carry workers' compensation insurance once they get much past the "solo entrepreneur" stage of operating. While the specifics vary from state to state, the fact that the coverage is typically mandatory makes providing it a potentially lucrative business for the companies involved in offering it.
That's a big part of what makes Employers Holdings so attractive as a potential investment. The company specializes in offering workers' compensation insurance to companies in low-to-medium-hazard industries. As a result, it collects those mandatory premiums and typically has to worry less about paying out claims than an equivalently sized company that works with higher-risk businesses would.
In the world of insurance, profits may or may not be made on the insurance premiums themselves, but insurers typically profit by investing the "float" -- that premium cash before it gets paid out as benefits. With a focus on lower-hazard industries, Employers Holdings has had the opportunity to amass a $2.8 billion portfolio (plus another $100 million in cash, give or take). That's not bad for a company whose market capitalization is only around $1.4 billion.
While workers' compensation insurance isn't necessarily a fast-growing industry, Employers Holdings is priced at around nine times its trailing earnings, a price that fairly reflects that stable business. Although the company's earnings are expected to drop in 2019 from their 2018 levels, overall it is expected to increase those earnings at a decent clip over the next five years. That modest valuation, along with decent growth prospects, makes Employers Holdings a sleeper stock worth considering now.
This ancillary pot stock could have investors seeing green
Sean Williams (KushCo Holdings): One of the most attractive small-cap stocks on my radar this month projects as a core player in the cannabis market: KushCo Holdings.
KushCo may not be much to look at for the time being. But that's to be expected from the nascent cannabis industry, which is experiencing some early-stage hiccups throughout North America. But rather than dabbling directly with the marijuana plant, KushCo is in the perfect position to benefit as a global ancillary provider.
Right now, the majority of KushCo's revenue is derived from vaporizers. With additional U.S. states expected to legalize recreational marijuana in 2020, and derivative products, including vapes, hitting dispensary store shelves by mid-December in Canada, KushCo should see a healthy expansion of its top-line sales over the next couple of quarters. Not surprisingly, Wall Street expects sales will nearly triple in 2019 from the prior year, then grow by nearly $100 million (a little over 60%) in 2020.
One added note: The company recently made the decision to stop eating tariff expenses on Chinese imports and will instead pass along higher costs to customers. Between the second and third quarters, we've already witnessed an improvement in gross margin of nearly 5 percentage points, and we should see continued margin improvement as KushCo passes along expenses to a demand-driven market.
KushCo also generates revenue as a provider of compliant packaging and branding solutions to the marijuana industry. Since marijuana laws can differ at the federal, state, and local levels, KushCo ensures that growers remain compliant, and that they stand out from the crowd. This is a segment that should increase as a percentage of total revenue as Canada and key U.S. markets (e.g., California) work out their early-stage kinks.
Lastly, the company also generates revenue as a supplier of hydrocarbon gases and solvents. The former are used in the production of cannabis oils, whereas the latter are instrumental in concentrate development. As derivative products really gain hold, being a supplier of hydrocarbon gases and solvents could provide fruitful for KushCo.
At less than 1.7 times 2020's full-year revenue, KushCo looks to be a bargain in the high-growth cannabis industry.
A stealth tech company
Brian Feroldi (Proto Labs): Proto Labs is a quick-turn parts maker, so you might assume that it's just another manufacturing company. In truth, Proto Labs is a technology company that just happens to focus on the manufacturing sector.
When a designer is tinkering in their lab they often want to create a physical part out of plastic or metal so they can see how it works in the real world. Most prototyping companies require weeks of lead time before they can make a part, but Proto Labs can get a part in a designer's hands in as little as 24 hours.
How is this possible? Proto Labs' secret is that it created proprietary software that automates the design, quoting, and pricing process. The software is so smart that it can also make design suggestions that can speed up the manufacturing process and lower costs.
Proto Labs' speed advantage is attracting designers in droves. Last quarter the number of unique product developers grew 5% to more than 20,800. This means that Proto Labs continues to have success at onboarding new customers and is a great sign for the future of the business.
Admittedly, Proto Labs' recent financial results don't look so hot; revenue grew just 5%, and its adjusted earnings actually declined. Those results were caused by weakness in its sheet metal business and a pullback in its margins. The global trade war isn't great news for business, either.
Management has put a plan in place to fix its issues and get its growth trajectory back into double-digit territory again. Wall Street believes in that plan and currently projects that revenue growth will accelerate next year into the double digits and that profits will grow almost 20% annually over the next five years. Those are exciting numbers for a company trading for less than 30 times next year's earnings estimates.
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Brian Feroldi owns shares of Proto Labs. Chuck Saletta has no position in any of the stocks mentioned. Sean Williams owns shares of KushCo Holdings. The Motley Fool owns shares of and recommends Proto Labs. The Motley Fool owns shares of Employers Holdings. The Motley Fool recommends KushCo Holdings. The Motley Fool has a disclosure policy.