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You Simply Can't Ignore These Stocks

Overlook some winners at your own expense.
/ Source: Motley Fool

Traditional investing logic tells us that, when the economy turns sour like it has, we ought to flock to undervalued large-cap stocks. Not only do they have better access to capital than smaller companies do, but they also attract the smartest and brightest business minds.

If the recent market implosion has taught us anything, though, it's that a poorly run large company can fall harder than a poorly run small company in an unforgiving market. In fact, some small companies have adjusted much better than their larger counterparts have.

Castles made of sand
Certainly there's still some merit in the conventional approach -- one could do far worse than buy quality names such as Procter & Gamble (NYSE: PG) and ExxonMobil (NYSE: XOM) at current prices, as both of these blue chips have solid balance sheets and continue to attract top talent.

Yet there was no shortage of talent wanting to get in the doors of Lehman Brothers, Wachovia, and Bear Stearns -- in fact, all three employers were among the 100 "most desirable" MBA employers in 2008, according to a Fortune survey. If traditional logic held true, this high-caliber talent should have been able to recognize the companies' problems and correct them more quickly than a smaller company could. As we all know, that reasoning failed many investors.

In fact, a number of smaller financial companies -- such as Great Southern Bancorp, a Midwestern bank with $3.3 billion in assets -- have proved to be nimbler than larger-sized competitors such as JPMorgan Chase (NYSE: JPM).

Well-positioned financial companies such as Great Southern can capitalize on adverse market conditions by sweeping up other troubled companies' assets, as Great Southern did with Kansas-based TeamBank back on March 20. Shares of Great Southern have more than doubled over the past year.

Titanic flops
But it's not just the financials. Consistently poor execution at formerly large-cap American businesses such as Eastman Kodak and Ford has sent both stocks down to the single digits, with few signs of returning to their former glory. These companies employ tens of thousands and have had plenty of access to capital but simply failed to perform well over the years.

Now compare those giant tales of woe to the success of PetMed Express, a $430 million pet-drug prescription company that employs about 250 people. In July, the company reported revenue growth of 13% year over year, remained free-cash-flow positive, and kept long-term debt off its balance sheet. In August, PetMed Express also recently announced its first-ever dividend payment.

As a result, the company was able to fund itself through its own operations and had no need to beg (pun intended) for loans. As you might imagine, investors rewarded PetMed Express. Shares have risen by 30% over the past year, while the S&P 500 is down.

Bucking the dividend trend
Another reason investors traditionally turned to large caps in this type of environment was for their consistent and reliable dividends, but after 62 S&P 500 companies cut their payouts in 2008 -- followed by another 72 cuts or suspensions so far in 2009, according to S&P data, from companies including Macy's (NYSE: M) and Pfizer (NYSE: PFE) -- it's clear (or more clear than usual) that no dividend is guaranteed.

Indeed, in a conference call after the dividend cut, Macy's Chief Executive Terry J. Lundgren said, "We just believe that this is a time when nothing should be considered a sacred cow."

It's discouraging to see so many blue-chip companies that have paid or raised dividends for decades suddenly changing course and blaming their mistakes on the macroeconomic picture, but there are still companies out there, large and small, staying true to shareholders with dividend increases in this market.

One of those companies is $3.3 billion clothing retailer Guess?, which, in August -- despite operating in the same consumer spending environment as Macy's -- increased its quarterly dividend by 25% on the heels of an increase in sales and profits for the quarter.

Guess? is able to do this because it isn't burdened by debt (it has no long-term debt whatsoever), and it generates plenty of free cash flow. So it has plenty of room to raise dividends or reinvest in the business for the benefit of its shareholders.

Choose your weapons wisely
In a market where economic agility and strong management matter more than ever, make sure you're studying well-run small companies alongside larger companies. For my money, I want to own companies, regardless of size, that have a strong management team, have a rock-solid balance sheet, and dominate their market niche.

One of the companies I've been researching recently is Darling International (NYSE: DAR), a $570 million company that fills a niche not many others want to fill: collecting food-service waste (grease and discarded meat) and rendering or recycling the waste into usable by-products such as animal feed, industrial oils, and even biofuel.

It's not only the largest company in this field (and the only one that's publicly traded), but it also has contractual relationships with big names such as McDonald's (NYSE: MCD) and SUPERVALU grocery stores. It's a cyclical business, to be sure, but Darling has positive free cash flow, more cash than long-term debt, and tenured management -- so it's worth your time to research.

If you're looking for more small-cap ideas for this market, our Motley Fool Hidden Gems team can help. Among other things, they look for stocks that are:

  • Underfollowed on Wall Street.
  • Led by dedicated founders.
  • Financially strong.
  • Well managed.
  • Dominant in their market niche.

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This article was originally published March 20, 2009, and has been updated.

Fool analystTodd Wenningis an equal-opportunity investor. He owns shares of Procter & Gamble,a Motley Fool Income Investor recommendation.Pfizer is a Motley Fool Inside Value pick. The Fool owns shares of Procter & Gamble and has adisclosure policyas fast as greased lightning.