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Two Leaders in Home-Related Niche Markets Look like Buys say Insiders

By Michael Brush
Exclusively for InvestorIdeas.com
July 27, 2006

Are the days in the sun over for small cap stocks? Many market strategists think so. Small-cap stocks have outperformed for too many years now, plus they tend to suffer when the economy slows.

I don’t agree with this gloomy view on small cap stocks – chiefly because I am more optimistic on economy than many market strategists these days.

Here’s why.

Despite the long rate hike campaign by the Fed, interest rates are still at lows normally associated with recessions.
Yes, consumers are pulling less money out of their houses through refinancing. But employment is strong and that’s picking up the slack. The consumer is not rolling over yet.
True, liquidity growth seems to be slowing. But there is still a lot of cash out there. Companies are awash in it, and personal net worth continues to break new records.

But just in case the gloomy crowd is right about small-cap stocks – normally the mainstay of this column -- as a hedge I think it’s time to put out a few larger cap names in this column. Besides, many larger companies that are quality names and leaders in their space are getting beaten up pretty bad – but insiders are seeing value.

Why not take advantage of this? We will, with a building and construction supplier known as Fastenal (FAST), and Pool Corporation (POOL), the world’s largest distributor of pool supplies.

Fastenal

As the name suggests, the Winona, MN-based Fastenal sells things that stick and fasten stuff to other stuff. Fastenal has over 1,700 stores in the U.S. and abroad, served by an efficient hub-and-spoke distribution system. With a product line up that runs the gamut from adhesives and screws, to bolts, clamps, weld fasteners and power tools, this is a company that clearly has exposure to the building sector.

This has to explain part of the 29% decline the shares of the leader in this niche space have suffered since early May when it traded at $49.30. The stock recently sold for $35. Fastenal shares also took a big blow in July when it missed quarterly earnings. The problem wasn’t sales growth – which was healthy at 19.7% -- but earnings growth. Earnings came in under expectations because margins were lower since the company added a lot of sales staff during the quarter.

Cheap stock

Down at these levels, however, the stock looks cheap. BB&T Capital Markets analyst Holden Lewis says Fastenal shares trade at around 20.5 times earnings expected over the next twelve months. This is well below the range for the past six years of 22.5 to 32.5 times forward twelve-month earnings. “We think much of the downside risk in the name is squeezed out, and there could be upside back north of $40,” says Lewis.

Insiders seem to agree. Four different insiders including the chief executive and the finance chief have bought over $500,000 worth of stock since it slipped under $40.50 in early June. The company also started a $20.5 million buy back program on June 13. By mid-July it had purchased $9.4 million worth of stock at an average price of $37.73.

Sources of growth

What might move the stock back up?

Lewis says over the years he’s been impressed with management’s ability to “clamp down on a problem quickly, and we suspect this quarter has goaded them into that mode.” He says the company is pulling back on hiring – efforts that will shore up some the weaknesses that surfaced in the most recent quarter. “We think this management team is very good at making midcourse corrections, and it is doing so now,” he says.

Beyond that, here’s the source of the 21% compound annual sales growth expected over the next five years by Morningstar analyst Matthew Warren.

Chiefly, the company is planning on 13%-18% growth in stores each year. Each new store adds to Fastenal’s buying power with suppliers. And new stores will spread out more revenue over the existing transportation and distribution systems, boosting margins. Fastenal is also accelerating its international expansion, especially in Canada and Mexico. International sales now account for about 6% of revenue.

Warren thinks fair value for the shares is $53, which means that based on his calculations on growth, that’s where the stock should be trading. He says Fastenal shares are worth buying anywhere under $45.

Pool Corporation

This Covington, LA-based company is the world’s largest distributor of pool supplies, with 258 service centers throughout North America and Europe.

Concerns about a housing market slowdown and potential consumer weakness help explain why Pool shares have fallen 20% to $39.50 since April, says David Mann, an analyst with Johnson Rice & Company.

If that’s what’s wrong with the stock, then like Mann, I say the market has it wrong. The consumer is far from rolling over. And while housing growth has cooled off, low interest rates and economic strength will be enough to keep housing growth on track, despite slowing in some regional markets.

Insiders seem to agree. Three insiders, including the finance chief, have purchased over $1.6 million worth of stock since June 8 at prices between $39 and $41, or around current levels. During the most recent quarter the company bought over one million shares at an average price of $42.43.

Johnson Rice & Company’s Mann says the following factors will help Pool.

The consumer doesn’t seem to be slowing down. Management recently indicated July sales are strong and tracking trends in the second quarter.
Pool builders are working at capacity. And new pools, obviously, are a main driver of growth for Pool.
The company also has strong recurring revenue from an installed pool base.
The industry is entering the early phase of an equipment replacement cycle in the installed base.

The bottom line: Fastenal has a market cap of $5 billion and Pool has a market cap of $2 billion. So these aren’t the kind of small-cap stocks we lean towards because the insider signal works better with smaller companies. But these are still relatively small companies. And it doesn’t hurt to start moving up in market cap if there’s a risk that small-cap stocks might lag after so many years of good performance. I’d buy both of these stocks right here.

Disclaimer

At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.

For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

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