2 attractive US small-cap stocks to buy

We’re always on the lookout for small companies that, over time, may grow into solid, mature entities. Two US companies—The Gorman-Rupp Company and PC Connection, Inc.—have that potential.

US_Small_Cap_StocksIn the course of a week, we get many emails from companies who are interested in having their firms recommended in The Investment Reporter.

Our challenge is to be able to ferret out the stocks with potential and dismiss blatantly obvious promotions. Recently, we’ve discovered two US small-cap stocks—The Gorman-Rupp Company and PC Connection, Inc.—that we believe are attractive for long-term capital gains, and are a buy if you can tolerate higher risk.

What is a small-cap stock?

We define a US small-cap stock as one that has a market capitalization (stock price times the number of outstanding shares) below US$1 billion.

Three risk factors that small-cap companies face are a limited access to capital, inexperienced management and volatile sales demand. If any one of these conditions becomes negative, earnings and share prices may plummet.

You may reduce your risk by following the ‘basket approach’. It involves purchasing at least five small-cap stocks to increase your odds that one may rise dramatically in price to pay for your other four small-cap holdings.

If you buy a small-cap, be patient. Give the company time to increase profits and its share price.

Manufacturing stock offers growth and income

The Gorman-Rupp Co. (NYSE—GRC), with a market capitalization of US$763 million, designs, manufactures and globally sells pumps and pump systems for use in water, waste-water, construction, dewatering, industrial, petroleum, original equipment, agriculture, fire protection, heating, ventilating and air conditioning (HVAC), military and other liquid-handling applications.

The officers and directors of the company own 12.4 per cent of the common shares.

Gorman-Rupp has a strong balance sheet with no short- or long-term debt.

It’s free cash flow positive. In 2017, its cash flow was $44.1 million, which easily covered capital expenditures of $7.8 million and dividend payments of $12.3 million, leaving it with $24.1 million in free cash flow.

Gorman’s 2017 operating income was $37.9 million, up 6.1 per cent from the year before. The operating margin improved to 10.0 per cent from 9.3 per cent in 2016.

Gorman’s free cash flows will likely be used for future acquisitions and new product development. This, in turn, should support even more cash flow growth.

Gorman’s shares trade at 14.2 times its 2018 estimated cash flow of $2.05 a share. Historically, the shares have traded around 17 times cash flow. Meanwhile, the stock pays an annual dividend of $0.50 a share, which yields 1.7 per cent. Gorman-Rupp is a buy for growth and some income.

A tech stock to buy for growth

PC Connection, Inc. (NASDAQ—CNXN), with a market capitalization of US$671 million, is a national solutions provider of a wide range of information technology, or IT, solutions. The company helps its customers design, manage and service their IT environments.

The officers and directors of the company own 57.3 per cent of its common stock.

PC Connections also has a strong balance sheet, with no short- or long-term debt.

In 2017, it earned $65.2 million in cash flow, which covered capital expenditures of $11.8 million and dividend payments of $9.0 million, leaving it with $44.4 million in free cash flow. (Note that the dividend payments were for preferred stock; the company pays no regular dividend on its common shares.)

Operating income, however, declined 3.7 per cent to $77.5 million, due to an increase in selling, general and administrative costs. Consequently, the operating margin declined to 2.7 from 3.0 per cent. As the company integrates recent acquisitions, though, costs may come down in future quarters.

PC’s healthy balance sheet (in addition to no debt it has $50 million in cash) and cash flows give it the flexibility to pursue further acquisitions. Then too, it may choose to pay a more permanent dividend after declaring a special dividend in January.

PC is expected to earn $2.55 a share in cash flow in 2018. This tech stock trades at 10.3 times that amount, in line with its historical multiple. PC Connection is a buy for growth.

This is an edited version of an article that was originally published for subscribers in the April 13, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

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