Barron’s recently published an article discussing the promise of small-cap funds heading into 2024. The rationale behind the thinking is that it’s possible any recession next year will be a small one. Small and micro-cap stocks do poorly in extended recessions.
It’s hard to know what’s going to happen next week, let alone next year. However, even when buying micro caps, it helps if you look for quality. The stronger the business, the more likely it will survive any recession that comes our way in 2024.
As the Barron’s article points out, micro caps are less likely to get bank financing in a recession, or if they do, the interest rates would be much higher than what large cap could obtain.
So, it makes sense to look for micro-cap businesses that self-finance their operations through cash flow. It doesn’t hurt if they also have business models that won’t be hurt by lower consumer spending. I would say these are businesses with high return on equity.
Who are these businesses? I’ll find my trio of micro-cap stocks to buy from the iShares Micro-Cap ETF (NYSEARCA:IWC), which tracks the performance of the Russell Microcap Index, a collection of very small U.S. public companies with market capitalizations between $4 million and $4.6 billion.
Modine Manufacturing (MOD)
Unless I’m wrong, Modine Manufacturing (NYSE:MOD) is the only one of the three that I’ve never written about. It is the second-largest holding in IWC with a 0.72% weighting.
The company’s been in business for more than 100 years. It specializes in thermal management. It provides heating and cooling solutions to many markets, including HVAC, commercial vehicles, data centers, agricultural, construction and refrigeration.
In fiscal 2023 (March year-end), it generated adjusted EBITDA (earnings before interest taxes, depreciation and amortization) of $212 million on $2.3 billion in revenue, an EBITDA margin of 9.2%, which isn’t bad for a small industrial company.
It has two operating segments: Performance Technologies (56% of sales) and Climate Solutions (44%). The product group contributing the most revenue to Modine’s business are its Air-Cooled Applications, which account for 29% of sales, followed by Heat Transfer Products (22%), and Liquid-Cooled Applications (21%).
So, for example, with the Air-Cooled Applications products, it makes air-cooled heat exchangers for agricultural combines, allowing the vehicles to continue to perform in the hottest of summer days.
It’s in the middle of transforming its business to go after higher-growth markets such as data centers. As a result, it’s expected to grow revenues to $2.6 billion in 2024, with adjusted EBITDA near or more than $300 million. As a result, its free cash flow will continue to grow. By 2027, it expects free cash flow to account for 6-8% of sales, up from 2.5% in 2023.
Climate change alone makes it an interesting bet.
Sterling Infrastructure (STRL)
Sterling Infrastructure (NASDAQ:STRL) is having a big year in the markets. Its shares are up more than 95% year-to-date.
Based in Texas, the civil construction company builds bridges, highways, airports, light rail projects, and lots of other infrastructure-related projects. With the Biden administration committed to infrastructure renewal in this country, it’s not surprising that it finished the third quarter with a backlog of $2.4 billion, 41% higher than at the end of December 2022.
While its margins aren’t massive—its Q3 2023 gross and operating margins were 16.4% and 10.2%—it helps to have net debt of just $5.9 million according to S&P Global Market Intelligence.
“We had another excellent quarter for cash flow generation, bringing our year to date cash flow from operations to $331 million. We remain very well positioned to grow the business through both organic initiatives and acquisitions,” stated Joe Cutillo, Sterling’s Chief Executive Officer.
In 2023, it expects revenue of at least $1.99 billion, $252 million EBITDA, and $4.10 a share earnings. It trades at a low 15.9 times that forecast. You can see what this and the other micro-cap stocks earned their spots on our list.
If there is any business positioned for a recession, it would be Winmark (NASDAQ:WINA). The Minnesota-based franchisor operates five brands that focus on resale retail: Plato’s Closet (39% of stores), Once Upon A Child (31%), Play It Again Sports (22%), Style Encore (5%) and Music Go Round (3%).
Throughout the next couple of years, its revenues will fall, but not for the reason you think.
In the nine months ended Sept. 30, Winmark generated nearly $4 million in revenue from leasing income earned from its middle market equipment leasing business. In May 2021, it decided to get out of this business.
“Winmark Corporation (Nasdaq: WINA) announced today that it will no longer solicit new leasing customers and will pursue an orderly run-off for its middle-market leasing portfolio,” Brett D. Heffes, Chairman and Chief Executive Officer stated.
So, for example, while it generated nearly $4 million in revenue in Q3 2023, 32% less than a year ago. It will be lower in the fourth quarter and every quarter after that until it has no revenue.
But consider this, in the first nine months of 2023, its gross profit from the $4 million was approximately $578,200. Its operating profit in these same nine months was $40.8 million, or 65% of its $63.2 million in revenue.
The leasing business simply wasn’t cutting it. Worse, it was a distraction from its resale operations. Not surprisingly, its stock’s appreciated by 121% since that decision 29 months ago. If you are looking for micro-cap stocks, start here.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.