Small-cap stocks number in the thousands and offer investors the extremes of stock investing. On the one hand, some small caps are the great growth companies of tomorrow that will reward investors with 10,000% and up rates of return over the next decade. On the other hand, many small caps are struggling, distressed companies that simply can’t compete and are doomed to remain small-cap forever. The key to successful small-cap investing is to distinguish between the two types of small caps, which is what I tried to do in my previous article Value Investing and Value Traps: Separating Winners From Losers.

The first step in small-cap investing is to avoid the 56% of small caps that are underperforming losers and in Value Traps I offer some filtering criteria to consider in this avoidance effort. Namely:

• Fad booms that go bust
• Secular industry declines caused by global competition
• Technological or logistical obsolescence
• Declining profit margins caused by increasing competition, including patent expirations
• Aggressive financial accounting
• High debt load
• Bad management (i.e., value destroyers)

If you avoid small-cap stocks with these red flags, you’ve won more than half the battle. But eliminating the worst small-cap stocks still leaves hundreds of stocks to choose from – many of which will just be average — so readers have asked me to explain further what exactly it takes to qualify as a Roadrunner Stock.  In other words, what criteria do I look for to separate the average “ho hum” small-cap stock from the select few small-cap stocks that are set to outperform spectacularly and dominate their industrial niches?

There is a grey area of investment criteria that serve the dual function of both avoiding losers and isolating winners. For example, a stock’s beta (i.e., measure of the stock’s price volatility compared to the overall market) is defensive in that low-beta stocks – by definition – are lower risk than the average stock because they historically have suffered smaller losses during bear markets. But there is also evidence that low-beta stocks exhibit strong business fundamentals like stable cash flows – which investors value highly – and studies have concluded that low-beta stocks outperform the average stock.

Stock Screens Cannot Uncover Qualitative Attributes of Success

The real “secret sauce” to uncovering the small-cap Roadrunner Stocks primed to be the huge outperforming winners of tomorrow, however, involves positive and qualitative attributes that aren’t easily screened for by means of numerical thresholds. I touched on the importance of such qualitative characteristics in Value Traps when I quoted Warren Buffett’s preference for “wonderful” companies set up for “inevitable” success. Small-cap companies have not yet reached the critical mass necessary to enjoy “inevitable” status – Buffett admits this — but the concept of a good business model is still applicable to small-caps in terms of “highly probable.”

Buffett defines a “wonderful” business as one that:

generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very, very few businesses like this.

The key to a company generating high returns on capital is a sustainable competitive advantage. There are two types of competitive advantage: (1) cost advantage; and (2) differentiation advantage. Companies with such advantages are winners and profitable. Customers choose them because they provide better products or services and/or at a lower cost than any of their competitors. These winning companies boast above-average rates of return which, in turn, lead to above-average stock price appreciation. In a 1998 speech at the University of Florida (28:00 minute mark of the video or page seven of transcript), Warren Buffett uses the metaphor of a castle surrounded by a shark-infested moat. The moat can represent any type of advantage, be it customer service, product quality, intellectual property, real estate locations or low prices. But it’s got to be wide enough to keep competitors away from the profitable customers. For example, in the Internet context, Buffett and his octogenarian sidekick Charlie Munger believe Google has the largest shark-infested moat. Back in May 2009 at the Berkshire Hathaway annual meeting, Munger said the following:

Google has a huge new moat. In fact I’ve probably never seen such a wide moat. Their moat is filled with sharks and I don’t know how you to take it away from them.

A Competitive Advantage Must Be Sustainable

One can argue that return on capital is a quantifiable attribute that can be easily screened for. True enough, but the key is not simply a company’s current profitability but judging the sustainability of a company’s profitability. Only companies with an identifiable competitive advantage can sustain high profitability — and that requires qualitative judgment. One way to evaluate sustainability is to use hedge-fund manager Chuck Akre’s airport runway analytical framework:

• Akre uses an airport runway as a metaphor for competitive advantage and seeks to determine “how wide and long is the runway?” If the runway is too narrow, there isn’t much room for reinvestment and growth. If the runway is too short, there isn’t much time before competitors will match the company’s processes and erode its ability to generate abnormally high returns. Akre tells the story of Bandag, a manufacturer of tires and tire retread services. An intern at his firm was the first to recommend Bandag as a potential investment because it was highly profitable, routinely generating an annual return on equity (ROE) above 20%. Akre was skeptical because he viewed the tire industry as a highly competitive and commodity business with little room for competitive advantage. But when he looked deeper, he discovered that Bandag actually did possess a competitive advantage but it was not in the manufacture of tires. Bandag’s competitive advantage was in its relationship with independent tire distributors, who were fiercely loyal to Bandag. Akre determined that these distributor relationships were sustainable and ended up investing in the company.

• In analyzing reinvestment opportunities (i.e., runway width), Akre uses his 2002 investment in American Tower as an example. It turns out that building cell phone towers is an extremely simple business that can grow fast with very little incremental capital expense. More than one mobile operator can place its transmitters on a tower. This means that for each new mobile operator American Tower signed up for a given tower, the company’s profit margin was extremely high (70%) because the cost of  tower construction had already occurred and did not need to be repeated. Akre calls this high profit-margin business model “vertical real estate.” With mobile communications growing like wildfire – everyone and their mother was buying a cell phone – Akre was confident that American Tower’s profits would ramp up quickly as more mobile operators installed equipment on its towers. Akre was proven right; American Tower’s free cash flow rose quickly and it was able to easily pay off its excess debt.

Buffett would agree with almost all of Akre’s analysis, but he would probably discount the importance of the airport runway’s width (i.e., industry growth potential). I’m not arguing that industry growth potential is unimportant, but it is worthless without knowing the ability of a company to generate above-average profits. An industry can grow strongly without offering individual companies the ability to generate high profitability. As examples of huge growth industries that have generated miserable returns for investors, Buffett offered up automobiles, airplanes, and TV manufacturers during a 2008 meeting with business-school students:

Question: What industry will be the next growth driver in the 21st century and what do you see that supports that?

Buffett: We don’t worry too much about that. If you’d look at the 1930s, nobody could have predicted how much the automobile and airplane would transform the world. There were 2000 car companies, but now only 3 left in the US and they are hanging on barely. It was tremendous for society, but horrible for investors. The net wealth creation in airlines since Orville Wright has been next to zero. If a capitalist had been at Kitty Hawk and shot him down, would have done us a huge favor. Or look at TV manufacturers. There are hundreds of millions of TV’s, RCA & GE used to produce them, but now there are no American manufacturers left. 

Examples of competitive advantage include intellectual property that is patented, brand reputation, installed customer base (network effects), economies of scale that allow a company to be the low-cost provider, and government regulations that limit competition. As one software executive put it a few years ago: “The only real competitive advantage is that which cannot be copied and cannot be bought.”

The Power of Ideas

Having access to huge financial resources is helpful – especially for large caps — but is not necessary for small caps. Most small-cap businesses don’t need a lot of capital because they’re not building capital-intensive infrastructure like power plants, factories, or skyscrapers. Smaller companies are more likely to be selling products and services based on intellectual property, which is naturally provided by the company’s founder and employees.

I like small companies with something exceptional to offer.  Uniqueness is a competitive advantage, because it means that consumers can’t get what your company sells from anybody else. When there’s no competition, a company has almost unlimited pricing power. Ideas need not be new; they can become unique by how they are applied or integrated. Albert Szent-György,  the Nobel Prize winning Hungarian physiologist who discovered Vitamin C, once said:

Discovery consists in seeing what everybody has seen, and thinking what nobody has thought.

Classic Roadrunner companies are natural-born disrupters. They often demolish entire industries. For example, Priceline pretty much obliterated the traditional travel agency business… by making booking cruises, hotels and airline tickets easier and cheaper.

Big companies, on the other hand, often fall into a “legacy” trap. They become obsessed with protecting what made them successful in the past and ignore emerging challenges to their comfortable profitability. In 1975, Kodak passed on the first digital camera because they feared it would “disrupt” their profitable film-manufacturing business. Inevitably, others discovered the technology and launched the digital photography era. Kodak, once a thriving, quintessential blue-chip company barely clings to life today.

Bottom line: Small-cap outfits are launched on new ideas and technologies. They often smash the stodgy legacies of older companies… and become the blue chips of tomorrow. 

There you have it – the first critical component of a Roadrunner stock is sustainable competitive advantage.  But a second critical component is also needed for a company to be a stock-market winner over the long term: good management. Next week’s Small-Cap All-Stars report will discuss the importance of good management and – more importantly – how to identify it.