2023-06-14 10:01:59 ET
Summary
- Mega cap stocks have experienced short-term earnings growth due to investments in artificial intelligence and rallied the market YTD.
- Small caps have not yet benefited from AI and are struggling in the current environment of higher interest rates, yet the overlooked small caps have promising long-term earnings growth.
- In this series, I am covering small caps, that I found while screening for strong free cash flow businesses, high returns on ROA and ROIC and healthy balance sheets.
- Tecnoglass, a Colombian glass manufacturer, is the first small cap I am covering in this series.
- The company is trading at 11x earnings while growing revenue 50% in Q1. The balance sheet is strengthening as a result of record free cash flow generation and serious debt repayments.
By now, everyone should have noticed, the massive moves in the mega cap stocks, that have catapulted the market upwards. It all started with the investments of Microsoft into OpenAI, which caused the revelation of artificial intelligence. Investors following me could have benefitted by reading my articles on Meta (META) up 140% and Alphabet ( GOOG , GOOGL ) up 33%. Right now, it is time to leave those mega caps for what they are, and look for new value investments that have been overlooked.
Over the last weeks, I have done research into small cap stocks, since they have been underperforming the market for some time now. The Russell 2000 (IWM) has only gained 6.5% YTD, compared to a 12.5% gain of the S&P 500 ( SPY ). The first small cap company I cover in this article is the Colombian glass manufacturer Tecnoglass (TGLS).
The short-term earnings growth of large cap companies enjoyed a boost from focus on cost-cutting and the increase of use cases in AI. On the other hand, small cap businesses have not yet been able to benefit as much from AI than the large businesses, and are still struggling in the current environment of higher interest rates. In the last two decades, it was only rare, that the short-term earnings growth of small caps is lower than that of large caps.
Still, the long-term earnings growth for small cap companies is promising and a lot higher than that of the large cap companies. This is normal, since it is easier to grow a small business than a large business. Doubling the amount of employees from 10 to 20 is reasonable, but doubling 100,000 employees to 200,000 is extremely difficult.
In terms of valuation , the gap between large and small caps has widened even more. The forward price-to-earnings ratio for the S&P 500 LargeCap is now 18.5, compared to the 13.5 forward p/e ratio for the S&P 600 Small Cap (SLY) and the S&P 400 Mid Cap ( SPMD ). The forward p/e ratio of the MegaCap list hit a forward p/e ratio of 29.6. The MegaCap list includes Alphabet, Amazon ( AMZN ), Apple (AAPL), Meta, Microsoft ( MSFT ), Netflix ( NFLX ), Nvidia ( NVDA ) and Tesla ( TSLA ). History shows that it is not it is not often that the small caps are trading at a lower p/e ratio compared to the large caps. The current environment suggests that there are more investment opportunities in the small businesses.
Warren Buffett mentioned multiple times throughout his career:
Start going through a lot of companies, focus on smaller companies, there is more chance one is overlooked.
In my small cap research, I have focused on companies between the market cap of $500 million to $6 billion. This resembles the S&P 600 Small Cap 's size of businesses from $98 million to $6.8 billion.
Focus points:
- Strong free cash flow (Low Price To Free Cash Flow)
- Strong balance sheet (High Current Ratio)
- High Return On Invested Capital and Return On Assets (Preferably Above 9%)
Tecnoglass
Market cap: $2.1 billion
Price To Free Cash Flow: 13.3 / FWD 9.5
ROIC (Return On Invested Capital): 33% / AVG 5y 12.9%
ROA (Return On Assets): 22% / AVG 5y 7.2%
Current Ratio: 2.05
Tecnoglass is a Colombian producer of architectural glass, windows, and associated aluminum products. They operate as a vertically integrated manufacturer, meaning they control the entire production process, from raw materials to the finished product. Vertical integration has significant advantages, like cost-efficiency, lower lead times, quality control and ensures the products meet industry standards.
More than 90% of Tecnoglass' revenue comes from America. The company's products are used in commercial, residential and institutional buildings. While revenue for the latest quarter was up 50%, the backlog in Q1 grew from $651 million to $776 million, showing strong demand for the company's products.
Tecnoglass has been growing their capacity to keep up with the growing demand. The new capacity can increase sales to more than $950 million annually, compared to the $716 million of sales in 2022.
One of their projects was the Paramount Miami Worldcenter.
Surprisingly, Tecnoglass is not valued as a growth company with the price to earnings ratio at only 11. In comparison to some peers selected by Seeking Alpha, the stock is trading lower than the others, which have a similar market cap.
Even more, the business grew 50% in Q1 and is growing a lot faster than its peers, while none of this is reflected in the valuation. Of course, it is reasonable that growth normalization could follow in the following years, yet a P/E of 11 is extremely low given the fact that the company can still improve its operating leverage.
In addition, Tecnoglass' profit margin of 23% is outstanding. Again, doing way better than the peers in the industry.
The CFO of Tecnoglass, mentioned in the latest earnings call 23Q1:
So anything above what we're doing is going to come from operating leverage and further automation. I think we - over time, we can still gain maybe another 100 bps, 150 bps depending on the level of operating leverage that we can get. But we've been pleasantly surprised over the last couple of quarters, obviously, more to come, but the expectation is that we will be able to sustain what we've been doing and depending on operating leverage, hopefully, gaining a little bit more.
Higher gross margins are possible, if Tecnoglass can improve their operating leverage. However, sustainability in gross margins is the most important and a key to further success.
Tecnoglass is strengthening their balance sheet quarterly with strong cash generation, while growing the business at the same time. The cash can be used in multiple ways. First, with backlog growing, additional investments in capacity expansion need to be considered. If the backlog keeps growing at the same pace as now, then more investment will come, mentioned the CFO in the Q1 earnings call. Further, the decrease of debt is an option, but it is good to know that leverage (Net Debt/ Adjusted EBITDA) already decrease from 3x in 2017 to 0.1x now. So debt repayments should not be a high priority right now. Lastly, cash flow will be used for dividends. The dividend yield is 0.83%, but is increasing quickly with the latest increase of 20%.
Investors should expect the dividend to recover to the pre-COVID level as soon as 2024, since the company is reaching new records in revenues and free cash flow. A lot of large buildings had to be postponed during COVID, which caused damage to the glass manufacturer's business. The turnaround creates a new wave of dividend growth.
Takeaway
Tecnoglass is a perfect example of how great small businesses can be disguised in the market. The stock is trading very cheap considering the excellent progress the business has made in the last years. The company is benefitting from modernization in Florida (in particular Miami), New York and Texas.
I believe more and more cities will grow and use larger glass buildings to save space and create more incidence of light. Tecnoglass' products especially are seeing high demand in a weak housing market. A turnaround in the real estate market could create additional demand for the company. The stock offers both more upside in stock appreciation and dividend growth along the way. To me, Tecnoglass, looks like a low risk, medium reward compounder for the next decade. The balance sheet has de-risked immensely and is stronger than ever before. The vertical integration of the business is awesome and will have a lot of benefits going forward.
A risk to my thesis could be a large capacity expansion, followed by a decrease in demand for their products. Nonetheless, my first impression of the management team is that they are considerate in every step they take. Although the company is still grabbing market share, competition can always rise. The vertical integration of the business will make it hard to compete with Tecnoglass.
I do not have a position yet as I just found the company myself. However, I have become interested in starting a position, while doing my research. I rate the company a 'Strong Buy'.
The plan is to make this a 5 to 6 part series, where I cover multiple interesting small caps. This is the first series I start on Seeking Alpha. Let me know in the comments, what you think, and give me some feedback. Thank you for reading!
For further details see:
Unleashing The Power Of The Small: Tecnoglass's Backlog Is Surging Under The Radar