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Magic Diligence
Magic Diligence

4 Cash Gushing, Undervalued Small Cap Stocks With Zero Debt

April 08, 2014 | About:

One of my favorite things about the Magic Formula� Investing (MFI) strategy is that, with some parameters, you can use it to find interesting stocks in any kind of niche you want.

Looking for large, safe, dividend-paying stocks? No problem, just run a screen with a high minimum market cap and scan the results for dividend payers.

Looking for tiny, overlooked micro-caps where the market has ignored rapid growth and great prospects? Run a screen with a low minimum market cap, and if you use our screener, set a low maximum market cap as well!

And so on...

Today, I want to focus on a particular kind of stock. The kind that are favored by the most successful gurus and winning value investors.

I looked for four characteristics.

One, the stock had to be a smaller company, with a market capitalization under $2 billion dollars.

Two, the company behind the stock had to be a steady, consistent producer of free cash flow over 3 or more years. We don't want the small caps with one-time, unsustainable revenue bursts.

Three, the company has to have zero debt. With zero debt and positive cash flows, that would mean these companies operate with very low business risk, especially over the short-term.

And four, we are looking for stocks with low P/E ratios (or, conversely, high earnings yields). The strategy itself takes care of much of this for us.

Here are 4 stocks in our screens that meet the criteria:

magicJack VocalTec (NASDAQ:CALL)

magicJack sells the eponymous USB device that gives any computer a complete phone service, and collects the fees to access the related services (check out the link to learn more). magicJack's EXTREMELY low monthly costs compared to competitive VoIP and phone company plans has led to rapid growth, with almost 7 million registered users (up over 20% year-over-year). 2013 operating income came in at $47 million dollars, magicJack has generated substantial free cash flows in each of the last 4 years, and the balance sheet shows $55 million in cash (with ZERO debt). Put all this together with a very cheap 10 forward P/E ratio, and CALL makes for one interesting small cap opportunity.

PetMed Express (NASDAQ:PETS)

Also known as 1-800-PetMeds, PetMed Express is an online and by-phone way to order pet medications. The value proposition over buying meds from the vet is 3-fold: lower prices (10-15% below the vet), better selection (over 750 products), and superior customer service (driving repeat business). The company is a strong and stable cash producer, consistently generating free cash flow of 7-10% of sales for the past decade. The stock also looks attractive, with a 5.3% dividend yield, forward P/E ratio of 14, and trading within 6% of its 52-week low. And, of course, the company holds $34 million in cash with ZERO debt.

Pegasystems (NASDAQ:PEGA)

Pegasystems sells business process management (BPM) and customer relationship management (CRM) software. The value proposition here is that Pega's "Better Business Software" integrates the entire process of implementing a BPM or CRM from business requirements through to application programming, speeding up and simplifying the process for both the business and IT side. Pega boasts some impressive clients, including Cisco, Bank of America, and Vodafone. Pega has been growing nicely, with a 5-year average annual revenue growth rate of 19% and 32% in operating profits. The stock is over 30% below its 52-week high, has $157 million in cash, and - say it with me - ZERO debt!

Cato Corp (NYSE:CATO)

Nothing difficult to understand about Cato. This "value fashion" retailer has 1,320 locations in 32 U.S. states, focusing on clothing and accessories for girls ages 7-16. Cato continues to open 15-20 net new stores annually, and still has a good portion of the country to expand into longer-term. 3rd generation family CEO John Cato owns almost 40% of the company and has served in upper management since the early 1980's. Cato is a well-run outfit, with returns on invested capital of 15% for over a decade. The company pays a robust 4.2% dividend yield, has generated voluminous free cash flow for decades, and holds $241 million in cash with ZERO debt. With a forward P/E ratio under 10, the price looks attractive, as well.

About the author:

Magic Diligence
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

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