Forbes: Finding Innovators Among Small Stocks

August 14, 2013- 

By William Baldwin

Your big payoff may not come from a scientific
breakthrough. It may come from a company that looks like Starbucks.

If you want to make money off innovative companies, don’t look for robots and rocket ships. Instead, look for novel business methods.

That advice comes from William Martindale Jr. and Robert Mitchell, money managers who started the Conestoga Small Cap fund in 2002. They hunt for imaginative companies that are too small to make the Forbes Innovators 100 list but have the growth that might put them on the list someday.

Conestoga’s portfolio includes a company that has a way to expedite the delivery of tiny parts, a company that owns an indispensable database of commercial real estate and a vendor of algorithms that tell hotels how much to gouge. You could call this low technology–the place where inventiveness meets mundane product lines.

The mundane has paid off rather well for Conestoga. Over the past decade the $500 million fund has delivered an 11.4% annual return, 3.5 percentage points ahead of the S&P 500 index. That return is net of a 1.1% expense drag.

It’s possible, of course, to make a killing in high tech–if, say, the gene scientists you are betting on land a blockbuster drug. But you won’t find pharma startups among the 50 companies in which Conestoga has staked money. Per Mitchell: “It’s a binary risk,” a polite way of saying the fund is not going to put money on the FDA’s roulette wheel.

Nor will Martindale and Mitchell bet on a venture that has yet to turn a profit. They gave a brush-off to loss-making Tesla Motors, Martindale notes wistfully, missing out on the spectacular run-up in Tesla’s share price. They’d rather own a business that finances its innovation out of the profits from existing products.

Proto Labs, the widget outfit, fits the bill. Its customers are smallish manufacturers who order metal and plastic parts they put into other things. They need to go from blueprint to finished pieces in a matter of days, and Proto has the software and the machinery to make this happen almost automatically. Here, R&D does not mean cutting-edge science. It means going beyond thermoplastic elastomers into high-density polyethylene. Sales have doubled over the last two years.

Conestoga’s largest holding is in CoStar Group, which has assembled a pile of data on commercial buildings that is a must-have for brokers, tenants and developers. CoStar spends a lot of money collecting facts–counting parking spaces, for example–and a lot of money writing software to make sense of the facts.

Pros Holdings concocts innovative pricing formulas. Classically, the game of price variations had an airline or hotel trying to unload expiring inventory on bargain hunters without disturbing the prices it was collecting from regular customers. Pros has taken techniques learned in the travel business into new territories. Its website lists such clients as a manufacturer of air-conditioning equipment and a distributor of industrial products, and boasts of helping them put an end to overly generous discounting.

Economic growth is all about innovation, but only some of it is as dramatic as inventing the lightbulb or creating the aerospace industry. A lot of it is as pedestrian as delivering parts faster or jacking up prices in an artful fashion.

Consider the simple business of selling cups of coffee. An innovator came up with a way to translate “coffee” into Italian and double the price. That clever idea turned out to be worth $50 billion, to judge from the excess of Starbucks’ market value over its tangible assets.

Martindale and Mitchell have a checklist of desirable attributes in a growth stock: a 10% or larger stake held by managers, a return on equity of at least 15%, debt less than two-thirds of shareholders’ equity and a business line that newcomers cannot easily replicate.

But every investor wants beautiful businesses with beautiful balance sheets, so you have to pay a premium to get in. In relation to either sales or cash flow from operations, the Conestoga companies are collectively priced at more than double the level of the Russell 2000 Growth index. (These statistics come from Morningstar, like CoStar a database company and a Conestoga holding.)

There are risks. What if Amazon went into Internet ordering systems like the one at Proto Labs? What if Google copied CoStar’s collection of building photos?

Growth companies suffer attacks from below, too. One of the Conestoga favorites is Simpson Manufacturing, an innovator in construction ties for wood-framed buildings. These are straps that cut the cost of labor and reduce the risk that a building will come apart.

Simpson is proud of its research labs, which include an earthquake simulator. But a metal strap is still just a metal strap. Simpson lost its business at the Lowe’s hardware chain when a subsidiary of Warren Buffett’s Berkshire Hathaway horned in with a discount.

In short, when you buy a growth company you have high expectations but also a high risk of disappointment. That’s true of all the Conestoga picks displayed in the table. The good about successful innovators: They spend heavily on R&D, and get that investment back in sales growth. The bad: They are priced at steep multiples of earnings–steep enough, at any rate, to scare away a value investor like Buffett.