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3 Small Caps With Room to Run

Small companies have been on a roll, but these stocks still look undervalued.

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After a chilly winter, stocks sprung to life over the second quarter. The Morningstar US Market Index is up 9.5% over the past 13 weeks through May 31. Small caps in particular are on a roll--the Morningstar Small Cap Index is up nearly 14% over the period.

Of course, there's no saying if small caps' momentum will continue in the short term. And in fact, after an asset class has done well is often the worst time to jump aboard that train; many investors do so, only to find themselves buying high and selling low. Instead, investors would be wise to be naturally skeptical about valuations and consider the possibility that future returns may well be lower. But that doesn't mean you need to abandon stocks and asset classes that have appreciated if you are careful about valuations.

We employed our  Premium Stock Screener to find some small-cap picks our analysts think have plenty of room to run over the long haul. First, we screened by market cap. Morningstar's stock size classifications are dynamic; we define small caps as the bottom 7% of the investable universe by market cap. (Currently, the upper limit for small caps based on that measure is $3.9 billion, so we screened for companies smaller than that.) 

Then we screened for stocks on our coverage list that were rated 4 or 5 stars, which indicates that we think they are undervalued relative to our estimate of their fair value. We then we looked for companies with a fair value uncertainty rating of Medium or lower, which means we think we can more tightly bound the fair value because we can estimate the stock's future cash flows with a greater degree of confidence. Finally, we looked for stocks with an economic moat rating of wide or narrow (meaning we think they have advantages that will fend off competitors for at least 10 years). 

As of June 1, our screen returned six companies. (To see the complete list and adjust the inputs to your specifications, please click  here.) Here's a closer look at three stocks that made it through the screen.

 WESCO International (WCC)
Four Stars
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Fair Value Estimate: $67.00
Wesco International distributes electrical, industrial, and communications supplies to its customers, mainly in the industrial and construction industries. The company has created a competitive advantage by becoming a key link between 25,000 suppliers and 75,000 customers—specifically, it has positioned itself as a middleman between a fragmented customer base and a large number of vendors, which makes it an important source of information and products to its customers, said Morningstar senior analyst Kwame Webb in a recent  Analyst Report. "Suppliers appreciate Wesco's ability to stock channel inventory and provide feedback on how products are or are not satisfying customer needs. The ability to act as an intermediary is more efficient for both constituencies than a direct relationship," said Webb. In addition, Webb notes that as one of the largest distributors in its end markets, Wesco can take advantage of vendor rebates that can often add 100-200 basis points to gross margins; smaller distributors are not in a position to capitalize on the same volume discounts. 

That said, there have been some headwinds here: Webb recently reduced Wesco's fair value estimate to $67 (from $72) to reflect weaker 2015 and 2016 revenue growth and diminished pricing power in an environment of falling customer volumes in the oil and gas and nonresidential construction sectors. However, he believes Wesco remains attractive and is one of the few undervalued names in the industrial distribution sector for investors interested in the group.

 Boston Beer Co (SAM)
Four Stars 
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Fair Value Estimate: $180.00
The craft beer industry has grown at a torrid pace in recent years, but it remains highly fragmented, with nearly 4,000 breweries (both distribution-based and brewpub models). U.S. craft brewer Boston Beer has carved a narrow economic moat based on its strong brands (including Sam Adams beer and Angry Orchard cider), better distribution network, and better negotiating power than other craft brewers, says Morningstar sector director Adam Fleck. However, there are some concerns lately surrounding Boston Beer--mainly stemming from its products' failure to resonate with consumers and competition from other craft brewers. In fact, Fleck recently reduced the company's fair value estimate to $180 from $209, citing "Sam Adams' share loss and the unexceptional performance of new products." Nonetheless, Fleck thinks that the shares look undervalued and expects Boston Beer to enjoy mid- to high-single-digit growth over the next five years, with benefits of additional scale making their way to the bottom line. He recommends, however that investors seek a sizeable enough margin of safety to account for "the uncertainty surrounding the firm's slate of new product introductions and the timing of a rebound in hard cider volumes."

 Compass Minerals International (CMP)
Four Stars
Economic Moat: Wide
Fair Value Uncertainty: Medium
Fair Value Estimate: $89
Compass Minerals produces rock salt for use in road and highway de-icing. Compass owns the world's largest active rock-salt mine in Ontario, whose thicker seams allow for more efficient mining operations. In addition, the mine is located on Lake Huron, giving Compass easy access to snowy markets located along the Great Lakes. These assets are difficult, if not impossible, to replicate, giving the firm a sustainable cost advantage over other producers, says Morningstar senior equity analyst Jeffrey Stafford. Last winter's warmer weather has weighed on Compass lately; as Stafford explains, de-icing salt sales volume is determined during the winter months and is strongly linked to the number of snow days per season. As such, weather has a big impact on Compass' year-to-year results, and salt volume fluctuates considerably. That being said, Stafford notes that highway deicing salt prices are relatively stable, and Compass' average selling prices in this area have increased year over year in each of the past 10 years. In addition, Compass is also a cost-advantaged producer of its other main product, sulfate of potash, which is a specialty fertilizer used by growers of high-value crops that are sensitive to standard potash (muriate of potash, or MOP).

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