In a recent blog post, we described how to create a screen to spot stocks using indicators that appear to be important to Warren Buffett. Our screen focused on a few fundamental indicators and targeted companies with high return on equity, strong cash flow and management teams that maximize the return on assets investors have entrusted to them.
We used the free screening tool at the FinViz web site and applied the setting shown below.
As we noted, our screen serves as a reasonable starting point for additional research. One avenue for research is in stocks Buffett cannot buy.
He runs a big company, Berkshire Hathaway (NYSE: BRK-A), with a market cap of more than $400 billion. Earnings before interest, taxes, depreciation, and amortization topped $44 billion in the past twelve months. Berkshire owns more than $120 billion worth of publicly traded stocks and has $75 billion in cash on its balance sheet. He reported about $6.5 billion in capital gains last year.
Buffett considers himself to be an elephant hunter. He is forced to focus on large cap stocks because his portfolio and company are so large.
Let’s imagine Buffett discovered a small cap stock he likes and he invests $5 million in the company. Once he reported his ownership through Securities and Exchange Commission filings, it would be difficult to get out of the stock. Some buyers would rush in to follow in his footsteps, decreasing the liquidity of the stock since they would be investors planning to hold for the long term. Without liquidity, Buffett would move the market against his position when he tried to exit, costing him money and taking time away from more promising investments.
Ignoring the mechanics of trading small cap stocks, Buffett faces another problem. These investments simply won’t matter to his performance.
Let’s assume the stock doubles in value and Buffett makes $5 million on his investment. This would amount to 0.0007% of the amount he recorded as capital gains last year. The gain would increase the value of his portfolio by 0.0004%. He would need to find 240 of these investments to add 1% to the value of his stock market portfolio.
Given the small impact small investments would have on his wealth, Buffett is likely to ignore small investments.
As individual investors, we do not have this problem. A small investment can have a large impact on our personal wealth and we can invest in the smallest companies in pursuit of wealth.
To take advantage of this flexibility, we added filters to our screen to hunt for small stocks Buffett could find attractive, assuming he could invest in this sector. Specifically, we looked for small caps with a market cap below $2 billion and a price below $5. We found four stocks.
Auxilio, Inc. (NYSE: AUXO) provides outsourced print management services and IT security consulting services to the healthcare, financial, and gaming industries, as well as others. The company’s managed print services assist hospitals and health systems to reduce expenses and create manageable, dependable document image management programs by managing their back-office processes. AUXO also provides IT risk management SaaS solutions; and managed services. In addition, the company sells multi-function device equipment; and offers cyber security professional services, such as penetration testing, cyber security risk assessment, and security program strategy development.
The company reported revenue of about $60 million in the past twelve months and earnings per share (EPS) of $0.32 over that time. The stock is trading at about 14 times trailing earnings. AUXO is covered by one Wall Street analyst who expects the company to report EPS of $0.35 this year and $0.70 next year. At an average price-to-earnings (P/E) ratio of 15, a reasonable price target is $10.50. This would represent a gain of about 130% from the current price of the stock.
Cemtrex, Inc. (Nasdaq: CETX) provides electronic manufacturing services of electric system assemblies, instruments and emission monitors for industrial processes, and industrial air filtration and environmental control systems worldwide. In connection with the production of assembled products, the Company also provides services to its customers, including: automatic and manual assembly and testing of products, material sourcing and procurement, manufacturing and test engineering support, and prototype design services.
CETX reported sales of more than $100 million in the past twelve months and EPS of $0.62. The company is also followed by one Wall Street analyst. EPS are expected to decline to $0.51 in 2017 and rebound to $0.70 next year. An average P/E ratio of 15 provides a price target of $10.50, a gain of more than 200% based on the current price.
LightPath Technologies, Inc. (Nasdaq: LPTH) designs, manufactures, and distributes optical and infrared components including molded glass aspheric lenses and assemblies, infrared lenses and thermal imaging assemblies, fused fiber collimators, and gradient index GRADIUM® lenses. The company also offers custom optical assemblies, including full engineering design support for both optics and mechanics.
Two analysts cover LPTH. One expects EPS of $0.10 this year while the other forecasts EPS of $0.14. Next year, the more optimistic analyst expects earnings of $0.17 per share while the more pessimistic analyst forecasts EPS of $0.16. The consensus price estimate is $2.92, a potential gain of about 25%.
Planet Payment, Inc. (Nasdaq: PLPM) together with its subsidiaries, provides international payment and transaction processing, and multi-currency processing services at 103,000 active merchant locations in 23 countries and territories across the Asia Pacific region, the Americas, the Middle East, Africa and Europe. The company offers payment processing services that enable the authorization and settlement of payment transactions by providing the connections between the merchant, its bank, and the card association; and online access to advanced reconciliation and reporting services, as well as localized language support to its customers.
Six analysts have published estimates for this year with the consensus forecast being for EPS of $0.22. The consensus forecast for next year, based on five estimates, is $0.25. The target price for the stock, based on analysts’ forecasts, is $5.43, a potential gain of more than 40%.
PLPM, and our other three buy candidates, are all relatively small companies in larger industries. Their history of revenue and earnings could make them attractive as potential acquisitions to larger companies in their industries. In the case of a buyout, they could deliver even larger gains.
It’s reasonable to ask if the price targets on these stocks are too high or how stocks could be so significantly undervalued. The answer lies, at least partly in their size.
It’s not just Warren Buffett who avoids small stocks. Large mutual funds or investment managers with billions of dollars under management also generally limit their investments to larger companies. These stocks are not included in indexes are not bought by ETFs tracking indexes. There are some funds and investment managers that hold microcap stocks. Three of these stocks, all except AUXO, has attracted at least some interest from those managers and institutional investors hold more than a third of the shares in PLPM.
It is important to note that each of these stocks is covered by Wall Street analysts. That means there are reports being published that could attract the attention of institutional investors and a small amount of interest could result in a significant rally for these stocks. When looking at microcaps, it could be worth ensuring there is analyst coverage. Otherwise, the stocks may remain undiscovered for many years.