Ian Wyatt's favorite small-cap stocks

Jennifer Schonberger | Jul 29, 2008 10:45am EDT | Comment

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Ian Wyatt is the chief investing strategist of SmallCapInvestor.com and the chief executive officer of Bushiness Financial Publishing, a publisher of both free and paid subscription newsletters, e-letters, special reports and financial websites. Prior to Business Financial Publishing, Wyatt launched BizFN.com, a free investment website where individual investors could access research and analysis from money managers and financial advisors around the country. In 2007, Wyatt was selected as one of 60 entrepreneurs to participate in the Entrepreneurial Masters Program (formerly Birthing of Giants) at the Massachusetts Institute of Technology Sloan School of business, a three-year executive development education program.

What qualities do you look for in a small-cap stock? Have your criterion changed given the current macro environment?

“Increasing cash flow remains the single best measure to separate the haves from the have-nots. If a firm’s cash flows aren’t increasing, be wary. We look for strong top and bottom-line growth of 25% or greater on a quarterly and annual basis, a build up of cash on the balance sheet, a trend of successive upside earnings surprises and upwardly revised estimates. The company should operate in a favorable industry and markets that contain extraordinary growth potential.

“In the current environment we wouldn’t expect to find as many companies with 25% revenue and earnings growth, so in that sense, yes my expectations have been lowered. We pay closer attention to guidance in this environment, as the probability for downgraded outlooks is more likely.”

What are your favorite small-cap stocks with market caps of under $1 billion for the year and why?

“T-3 Energy Services (Nasdaq:TTES), Life Sciences Research (NYSE:LSR), Cano Petroleum (AMEX:CFW) and Merit Medical Systems (Nasdaq:MMSI) because of the specific niches they operate in.

“T-3 Energy manufactures and repairs equipment used in the drilling and completion of new and existing oil and gas wells, and for the production and transportation of oil and gas. The company has three product lines: pressure and flow control, wellhead and pipeline. Since April 2003, T-3 Energy has introduced 43 new products. As of March 9, the company had 18 manufacturing facilities located throughout North America.

“Equipment failure in the energy industry is not an option and as such T-3 Energy’s customers — namely many of the big exploration and pipeline companies as well as drilling contractors and pipeline companies — are reliant on T-3’s valves, wellheads and other devices that are engineered to handle intense pressure of 15,000 pounds per square inch and beyond.

“Demand for its products stems from exploration and development activity levels, which in turn are directly related to current and anticipated oil and gas prices. As oil prices have sky rocketed and the crusade to quench America’s thirst for oil has ramped up, the small cap has continually seen robust revenues.

“Earlier this month T-3 entered into a joint venture with Aswan International Engineering Company, who is a member of the Al Shirawi Group of Companies in Dubai. Aswan provides manufacturing, repair and remanufacturing of oilfield products for customers operating in the Middle East. This joint venture is another step in T-3's strategy of international growth.

“Life Sciences Research offers pre-clinical and non-clinical testing services for drug companies who want to outsource this function. It teams up with clients for Phase 1 clinical trials to independently verify results. The company is the largest provider of pre-clinical efficacy testing in the United Kingdom and Europe, and is globally one of the “big three” — the other two being Covance (NYSE:CVD) and Charles River Labs (NYSE:CRL).

“Life Sciences is sitting on an approximate 26% growth capacity. It has an estimated annual testing capacity of over $300 million.

“It’s currently estimated that 25% to 30% of pre- and non-clinical testing is outsourced and that the percentage outsourced going forward, as well as the absolute dollars that go toward outsourcing, is expected to continue to grow.

“Life Sciences’ growth is correlated with the pharmaceutical industry’s growth. As more and more potential drugs are tested for market, the need for independent research is expected to jump, which bodes well for Life Sciences.

“In the first quarter of 2008, new orders reached $71.4 million and backlog increased to $196 million from $190 million in fourth quarter 2007. Net income bolted 91% in the first quarter, while revenues grew 16.4%.

“Cano Petroleum is an independent oil and gas exploration and production company that has been reaping the rewards of sky rocketing energy prices, while most other companies continue to be hampered by the assent.

“The company has oil and gas properties in Texas, Oklahoma and New Mexico. Cano has several enhanced oil recovery (EOR) projects that are core to its business. The EOR method includes using such techniques as waterflooding and gas injection to increase the amount of oil that can be extracted from a reservoir. Unlike many large-cap oil companies, Cano focuses its business on mature oil fields. The benefits of focusing on mature oil fields include limited competition as well as virtually no exploration risk, as the company’s portfolio is comprised of proven reserves.

“For the fiscal 2008 year ended June 30, 2008, proved developed producing reserves increased 25% to 10.6 million barrels of oil equivalent, up from 8.5 million BOE. Oil reserves accounted for 72% of total reserves. Based on the ending June oil price of $140 per barrel and natural gas of $13.15 per mcf, the pre-tax net present value, discounted at 10% of the firm’s reserves is $2.24 billion.

“Merit Medical Systems makes disposable medical products used in radiology and cardiology. The company is a market leader in many of the products it offers, such as disposable catheters, syringes, inflation devices, disposable blood transducers, angioplasty needles and guidewires, pressure infusion bags, kits and procedure trays.

“Merit sells 72% of its products to U.S. hospitals, custom packagers and distributors, and original equipment manufactures, with the remaining 28% sold in international markets.

“The company received clearance from the U.S. Food and Drug Administration at the tail end of 2007 for three new products including, the Sea Dragon torque device, which is used specifically with hydrophilic guide wires; the All-Star hemostasis valve, which is designed to maintain a fluid-tight seal around interventional devices; and the Prelude marker tip introducer sheath, which allows visualization of the sheath tip for precise placement during interventional and diagnostic procedures. All three are high margin.

“Merit recently reported strong second quarter results after which the stock as spiked. Net income grew a hefty 62%, while revenues boasted an increase of 11% in the quarter. Gross margins were 42.7% of sales, compared with 37.7% of sales for the second quarter of 2007. The company boasts a current ratio of 3.5, so it is very liquid.

“Merit operates in a recession resistant space, which is also some of the appeal in the current environment. Demographic trends should also bode well for the company as baby boomers age and therefore we’ll see higher demand for health-care equipment.”

What’s your typical investment horizon when you’re generally investing?

“We don’t have one. It’s what the market yields. When it turns, be ready to unwind or accumulate — so it's an adaptive approach.”