Warren Buffett: Size Does Matter
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With year-over-year revenue growth of 27% and no signs of a slow down, unexperienced investors might mistakenly assume that Apple's P/E ratio of 12.2 is outrageously low. Why would a great company that is growing so fast trade at such a conservative valuation? Two reasons: (a) Phenomenal profits and growth attract well capitalized competition and (b) after companies achieve high levels of market saturation, achieving growth is more difficult. For these reasons, I always keep an eye out for great small cap investments, or companies with market capitalizations somewhere between $250 million and $3 billion--large enough to offer some stability and small enough to introduce great growth opportunities.
Size Does Matter
Warren Buffett caused quite a stir when he told Businessweek in 1996 that he believes he could earn a 50% annualized return if he had a smaller sum of money to invest:
"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."
In the 1950's Warren Buffett, of course, had much less money to invest than he did today. This allowed him to invest in smaller companies that would have no impact on Berkshire Hathaway's massive investment portfolio today. On the other hand, individual investor portfolios are plenty small enough to be able to benefit from any upside in a small cap stock (unless you are Bill Gates). Therefore, it is important we don't avoid small caps. Instead, individual investors would do well to seek out great small cap opportunities.
Three Solid Small Cap Investments For The Long Haul
Below I've picked out some small cap companies with Buffett-like characteristics: Sustainable economics, a profitable business model, and a healthy balance sheet:
BJ's Restaurants (NASDAQ: BJRI) excels by offering a more contemporary, higher quality, "casual-plus" dining experience for the same amount of money as the typical casual dining restaurants. As the $87 billion casual dining market struggles as a result of "fast casual" concepts like Chipoltle Mexican Grill and Panera Bread, BJ's home-brewed beer, American food, and warm atmosphere continue to resonate with customers.
BJ's offers more for less, giving customers a "casual-plus" dining experience at a an average check per customer of $13.50, just $0.50 higher than Brinker International's Chili's and more than a dollar less than steakhouse Texas Roadhouse. With a large portion of sales coming from high-margin beer and pizza sales, BJ's is able to maintain gross margins around 40%. Furthermore, its debt free expansion is nowhere near complete; Management plans to grow the number of its locations from its current 130 to 425.
Apparel retailer, Buckle (NYSE: BKE), boasts ten years of positive, upward trending free cash flow and a debt free balance sheet. Furthermore, its historical dividend yield amounts to a whopping 7% once special dividends are included. The company has managed to pay a special dividend every year since 2006 (accept 2007). If the company ever expands internationally there could be huge upside left in the stock. For now, management has been able to pay out large dividends while still managing to grow the company, resulting in a five year stock return of 150%, not including dividends.
The average annual earnings growth estimate for specialty retailer Hot Topic (NASDAQ: HOTT) over the next five years is 22.5%. The company operates with a debt free balance sheet and carries about $64 million in cash, equal to about 16% of the company's market cap. Based on the average price target for Hot Topic of $12.20, the stock has over 25% upside.
The Bottom Line
With zero long-term debt, growing revenue, growing earnings, and favorable long-term economics, these three companies are all worth a closer look. Their durable economics and healthy balance sheets reduce downside risk and their historical growth and future growth prospects represent potential for upside. And don't forget: Size does matter.
DanielSparks has no positions in the stocks mentioned above. The Motley Fool owns shares of BJ's Restaurants and The Buckle. Motley Fool newsletter services recommend BJ's Restaurants and The Buckle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!