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Investing Specialists

The Small-Cap Superstars Portfolio Considers Four Buys

We've added four companies to our watch list.

As we discussed in our first article, Morningstar's Small-Cap Superstars Portfolio, one of the best and easiest ways to screen for new investment ideas is by monitoring the activity and holdings of successful fund managers. In this portfolio, we aim to combine some of the best ideas from our favorite small-cap fund managers with the highest-rated stocks of our fellow analysts here at Morningstar. (For breaking news and updates on our Small-Cap Superstars Portfolio, be sure to sign up for our free e-mail alerts.)

Watch List
After running our screens we've come across a few new interesting ideas. However, we haven't added any new positions to the portfolio, because either the stock isn't quite cheap enough for our taste or there aren't enough top managers who own the stock. In the meantime, we'll keep a close eye on our small-cap managers' holdings as well as these companies' stock prices.  

Fair Value Estimate: $46.00
Consider Buy: $35.50
Administaff is the dominant player among professional employer organizations (PEO) that focus on human resource outsourcing for small businesses. In our opinion, high switching costs and outstanding profitability earn this firm a narrow moat. A PEO handles common HR functions such as employee benefits, payroll, and workers' compensation. This allows clients to focus on profit-growing initiatives instead of administrative tasks. The underpenetration of small businesses by HR outsourcing firms bodes well for pricing and profit growth. Administaff's desired client profile--high average employee salary, low workers' compensation exposure, and stable business profile--narrows the approximately 6 million small businesses in the United States to 600,000 opportunities. Given this large target market, it's not surprising that 65% of Administaff's new clients are outsourcing their HR functions for the first time. This lack of head-to-head competition for new business is a primary reason that returns on investment have been so favorable.

 MSC Industrial (MSM)
Fair Value Estimate: $60.00
Consider Buy: $46.30
MSC distributes industrial supplies through field salespeople, catalogs, and the Internet. While Home Depot Supply (recently sold to a group of private equity firms) and  Grainger's (GWW) multichannel strategies include branch stores that stock high-volume items, MSC's direct approach is fairly disruptive. By stocking 500,000 less-than-common items for next-day delivery (compared with 115,000 at Grainger), MSC provides unmatched selection and quick turnaround. Despite its higher inventory carrying costs, it is increasingly clear that MSC is a low-cost provider. Further, we expect MSC to experience strong internal growth as the industry consolidates. Currently, the top dozen or so distributors control 15% to 20% of the market, but this will change as domestic companies attempt to cut costs in the face of stepped-up global competition.

 Del Monte Foods 
Fair Value Estimate: $14.00
Consider Buy: $10.80
Del Monte Foods boasts a strong portfolio of brands, including Del Monte, Starkist, Kibbles 'n Bits, Meow Mix, Milk-Bone, and 9Lives. In fact, 80% of its retail sales are for brands that hold the number-one or -two spot in their respective categories. The company is moving up the value chain into higher-margin offerings, which should help mitigate commodity pressures and build brand equity. Analyst Ann Gilpin believes that Del Monte will benefit from increased spending on pets, which should boost sales of its higher-margin "gourmet" pet products. Health and wellness trends also bode well for sales of Del Monte canned fruit and vegetables, including organic varieties.

Fair Value Estimate: $41.00
Consider Buy: $26.10
Jarden is a roll-up of niche household and outdoor brands, including K2 skiing and snowboarding equipment, Bicycle playing cards, Coleman camping gear, and Sunbeam durables. The company holds the number-one or -two position in at least 21 niche categories. Management believes there's scope to add value to these brands by giving increased attention to innovation, cost-cutting, and cross-selling opportunities. While the stock is held by six of our favorite small-cap managers, analyst Ann Gilpin recommends holding out for a cheaper price, due to Jarden's high dependence on big box retailers and aggressive roll-up strategy.

Longleaf Partners
Since the middle of July, the stock market has been quite volatile due to concerns over consumer strength and the housing/mortgage market. However, two of our favorite managers, Mason Hawkins and Staley Cates of  Longleaf Partners Small-Cap (LLSCX), are licking their chops. In their third-quarter letter to shareholders, Hawkins and Cates wrote, "If the market's stabilization and recent strength proves ephemeral, we may ask existing and new shareholders for capital to exploit our on-deck list." In subsequent news articles, it was revealed that Longleaf is looking for $2 billion in additional capital. We'll be watching how Hawkins and Cates invest their dry powder over the next couple of quarters in hopes of sniffing out a few more ideas for our portfolio. 

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Small Cap Superstars does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.