4 Microcaps Warren Buffett Would Love

by: Daniel Agramonte January 28, 2008 | about stocks: AIRT / DCU / ELSE / WSCI    

Daniel Agramonte

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Early on, Warren Buffett took control of a small New England textile mill that became the namesake for his new company. Since then the company bearing the mill’s name, Berkshire Hathaway (BRK.A) (BRK.B), has witnessed incredible growth because of its ability to invest effectively. With a market capitalization in excess of $220 billion, Berkshire Hathaway no longer buys small companies. What if they did? Perhaps they would invest in microcaps, but which ones?

Tough Hurdle

Chances are they would focus on intrinsic value, which Buffett says, “is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses” and has been equated to the discounted cash that can be taken out of a business during its remaining life. Even though he is famous for buying stocks that were “cigar butts” with a few puffs left, Buffett has also invested in companies with strong growth prospects (e.g., Coca Cola (KO) moving into overseas markets) provided there was a nice margin of safety. With that in mind, consider these guidelines:

  • Price/book: Less than 3 and preferably below 2
  • % LTD/capitalization: Less than 30%
  • 4-year revenue growth: Greater than 20%
  • Quick ratio: Greater than 1.0
  • P/E: Below 25 and preferably below 13
  • Positive cash flow for at least the previous 12 months

Then There Were Four

In keeping with Buffett’s famous aversion, technology stocks were omitted from our search. Although the criteria initially identified numerous microcaps, those with poor earnings (defined as having had one more years of negative revenue in the past four years) or with complicated business models, were removed. The search resulted in the following four microcaps. Given that Buffett sees himself as buying the business as opposed to buying a stock, let’s take a look at what each company does:

  • Electro-Sensors (ELSE): Designs and builds speed sensing equipment for manufacturers. Anyone who has seen high-speed manufacturing has probably looked with amazement at how everything flows smoothly. ELSE helps its customers manufacture more efficiently, optimizing production rates. Customers include many Fortune 500 companies such as ADM, 3M, Anheuser-Busch, GM, GE, Ford, and Exxon-Mobil.
  • WSI Industries (WSCI): Manufactures very low tolerance (high precision) machined parts. They serve various industries that require highly precise parts: defense, aerospace, medical, etc. In business since 1950, WSI has recently entered new markets that offer tremendous growth opportunities. Current customers include: Polaris Industries and General Dynamics.
  • Dryclean USA (DCU): Founded in 1963, DCU is all about dry cleaning. They have subsidiaries that: (1) franchise/ license over 400 dry cleaners, (2) design and build equipment for laundry/dry cleaning facilities, and (3) broker the purchase and sale of dry cleaning businesses. Headquartered in Miami, they serve markets in the U.S., the Caribbean and Latin America.
  • Air T (AIRT): Has two business segments, both dealing with aviation services: (1) contracted express air cargo delivery, and (2) manufacturing aircraft support equipment such as scissor-lifts and deicing equipment. The contracted air cargo express air cargo service operates 95 aircraft that provide overnight delivery for companies such as Federal Express.

Below is a summary of the financials for all four companies. Where applicable, financials are based on the preceding 12 months:

click to enlarge

To keep things simple, intrinsic value was estimated using an equation borrowed from Warren Buffett’s mentor, Benjamin Graham:

Intrinsic Value = EPS * (2r + 8.5) * 4.4/g

Where:

EPS = Trailing 12 months earnings per share
r = Estimated annual rate of growth
g = Yield on AAA-rated corporate bonds

In Closing

Although no stock is perfect, all four of these companies have strong financials and a demonstrated ability to focus on growth while limiting debt. Based on a quick analysis, each company appears to be trading below its intrinsic value and provides a nice margin of safety due to a straightforward business model and solid management, resulting in reasonable debt levels, positive cash flow, and consistent earnings. Hopefully Warren Buffett would agree there is opportunity here.

Disclosure: The author has a position in WSI Industries Inc. (WSCI). The author does not have a position in Electro-Sensors Inc. (ELSE); Dryclean USA, Inc. (DCU); or Air T Inc. (AIRT). The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this article.

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This article has 4 comments:

  •  
    Jan 29 12:41 PM
    I was interested in ELSE based on your description and took a look at the numbers. Turns out that shareholder equity and tangible equity have trended *down* since 2004. There might be other bullish things about the company, but since your methodology was explicitly designed to find companies with good trailing performance, methinks the methods need some tweaking.
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  •  
    Jan 29 03:32 PM
    Josh
    Thanks for the feedback. As always with investment advice, caveat emptor (buyer beware). The approach here was designed to focus on companies showing strong value despite their modest size (since value investors typically restrict their focus to companies with more than $500 million in sales). There are many aspects of the company that you should look at and it goes without saying that microcap investors (as opposed to speculators) should perform a deep due diligence before deciding to own a specific comany. The guidelines here are simply starting points in the analysis and don't purport to be the definitive answer. Thanks again for your feedback.
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  •  
    Jan 31 09:13 PM
    To extend your analysis a little, as Buffett and Graham would say, cashflow returned to the shareholder in the form of dividends is also important. DCU = 5%, ELSE = 3.1%, AIRT = 2.7%, WSCI = 1.5%.

    Disclosure - I own DCU and have looked at and considered purchasing the other 3 at various times over the past couple years.
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  •  
    Feb 03 09:58 AM
    Daniel, I became aware that Warren Buffett bought See's Candy in 1973 when it was a microcap! Warren discusses the Qualitative and Quantitative reasons for that past microcap purchase at a Seminar for Flodida State MBA students available to veiw on Youtube.com Interestingly I am aware that Willameete Valley Vineyards a Wine producer in Oregon Listed on NASDAQ has uncannily identical Qualitative and Quantitative position as See's Candy in 1973! By the Way See's has increased free cash flow 20x in the last 24years that Warren has owned it ........Please examine WVVI , I'm interested in what you think. Tom .
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