Monday, June 12, 2006

Still Big on Small Stocks

In Barrons this weekend, there was an interesting feature on small cap stocks featuring an interview with Alexander and Alex Paris of Barrington Research Associates. They have presented a number of very interesting and unique ideas, some of which I would like to highlight.

The prevailing wisdom of the street seems to suggest that investors should be looking to larger cap names at this point in the cycle, whatever that may mean. Clearly, smaller cap companies have higher risks and rewards associated with them largely because of the nature of competition. The dominance of capital can quash the competitive advantage of many small cap names. With scale comes cost efficiency...sometimes. However, as with any conventional rule of thumb, the intelligent investor should be looking for opportunities anywhere they may arise, whatever the market cap. Though I certainly advocate using opportunities such as the current market to upgrade portfolios with predicatable and less risky names, and that generally means larger cap, on the other hand, one should not neglect an opportunity when it comes along.

One of the names mentioned was Gentex (GNTX) an auto parts business. Gentex manufactures and essentially invented the self-dimming electrochromic mirror. This has been a wonderful business that I have followed pretty much from the IPO completed many years ago at Furman Selz. The business has grown revenues by about 17% CAGR over the last ten years and similarly for E.P.S. The company has been conservatively managed from the balance sheet aspect since it carries no debt, and in fact has a cash balance of $3.85 per share. Sort of everything that you want to see in an auto parts business.

The valuation of the business also appears quite attractive at first glimpse. Enterprise Value is only about 13 times EBIT which seems fairly reasonable for a company with this growth record and a return on invested capital of about 13%.

The trend in ROIC has been decidedly downward as follows:

Unfortunately, the trend in gross margins has also headed southward:








These gross margin trends have been sequentially down each and every quarter since June of 2004.

Working capital management as well as slowed with the passage of time. Five year average inventory turnover has been 10.6 times versus a current 7.8 times. Accounts receivable turnover has also slowed slightly to 7.8 times versus a five year average of 9.2 times. Not horrendous but nevertheless noteworthy.

Needless to say, Gentex has shown stellar results in a very difficult environment. Their nemesis, Donnelly is a well-heeled subsidiary of Magna International (MGA) a magnificent company except for its attitude to minority shareholders. Ex- Frank Stronach and his consulting agreement, I could learn to love Magna. Clearly, gross margin pressure must be coming from here. As well, some 24% of Gentex revenue comes from GM. This is similar for Magna.

Magna generates ROIC of about 9%, significantly below that of Gentex but trades at an EV/EBIT of only 7.5 times relative to the aforementioned 13 times. Gentex looks expensive relative to the group, its quality generally justifies the price.

Unfortunately, given the uncertainties that I still hold regarding GM, the cyclicality of the auto business, and the slow erosion of working capital characteristics and gross margins, I have a hard time getting excited about Gentex, despite some real fondness for management and respect for its abilities.

Finally, I would like to remind people of Harman International (HAR) the most un-auto of the auto-parts companies in my view. Less than 10% of revenues tied to the Big 3 (at least the former Big 3) Similar earnings growth to Gentex at 17%+ for EPS with ROIC of 18%. Please check the post at :
Harman International-An Auto Parts Growth Story

Disclosure: Neither I, nor my family nor clients have a current position in Gentex or Magna. Neither I, my family have a current position in Harman International. However, some clients do have a current position in Harman International.


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