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Three Big Trends and Three Small-Cap Stocks

Trend analysis is critical when researching small-cap stocks. And these three small caps are benefiting from some of today’s biggest trends.

An Underlying Theme that Is Still Relevant Today

I’ve been reading Winthrop Smith’s account of the rise and fall of Merrill Lynch entitled, Catching Lightning in a Bottle. The book has nothing to do with small-cap stocks specifically. It’s mostly about the company’s culture and how differences in leadership style influenced Merrill Lynch’s performance over the decades.

But there are fascinating sections that delve into investment decisions that the company made, why it made them and how they worked out.

The overarching theme of the book is Charlie Merrill as a powerful force in improving the public’s perception of Wall Street. His efforts to make small investors feel that Merrill Lynch put their interests first helped pave the way from Main Street to Wall Street. It struck me throughout the book how a similar mission here at Cabot is helping our subscribers take control of their own investments, and make money by doing so.

But that mission, which began in 1970 with Tim’s father sharing his thoughts with subscribers on stocks and market timing, isn’t the point of my writing today. I want to talk about an underlying theme to Charlie Merrill’s investment advice that’s still incredibly relevant.

At about the halfway point, the book discusses the firm’s advertising campaigns from the late-1960s through the early-1980s. According to Smith, Charlie Merrill felt that good advertising and public relations were critical to help Merrill Lynch grow. And he tells the story of how the Chairman and CEO from 1971 to 1980, Don Regan (who went on to become U.S. Secretary of the Treasury, and then White House Chief of Staff under President Ronald Reagan), whose views on public relations were similar to Merrill’s, worked to revamp the firm’s advertising focus around “trends.”

For a number of years, with Don Regan’s guidance, the firm’s print campaigns featured a number of different trend-based themes, each designed to let the public know what Merrill Lynch thought they should invest in and why.

I found one of them from 1971, selling the idea that certain (not all!) retail stocks were a place to be. Here it is (I hope it’s clear enough for you to read):

There are a lot of things I like about this ad, one of which is how it is so clearly from a different era. I showed it to my wife, who’s not a big shopper to begin with, and we both agreed it wouldn’t fly today. But aside from the common (for the time) depiction of a housewife shopping for household items, it shows how big picture thinking is a timeless approach to investing.

Trends come and go, but investors’ desire to be in the right ones—and out of the wrong ones—is consistent over the decades.

A couple of details in the ad also caught my eye, most notably the three paragraphs that say, “One is the trend in housing starts. It’s up. Sharply. And more housing means more demand for appliances, furniture, and carpeting. Other bullish signs are the easing of credit and the downward trend in interest rates. They make it easier for people to buy the big-ticket items they put off during the recession. Finally, there’s the Federal Government acting to bolster the economy. That should help to shore up consumer confidence. And loosen purse strings.

Sounds familiar, right? I don’t know what specific stocks Merrill Lynch Account Executives were recommending at the time—the ad only says “well-established mass merchandisers”—but it wouldn’t be a stretch to think that similar stocks would work today. Hindsight certainly shows that they were right about interest rates. Look at this chart of the 10-Year U.S. Treasury Yield dating back to 1980.

They were also right about the trend in consumer spending—there’s no doubt it has increased dramatically over the decades since 1970, as interest rates have fallen.

You’ve Gotta Have a Big Idea

So what does this have to do with small-cap investing? A lot, actually. There’s no doubt in my mind that focusing on big picture trends remains one of the keys to successful growth investing. Not so much when it comes to analyzing a specific stock, but definitely when it comes to formulating an opinion on whether a small company has the potential to become the next Microsoft (MSFT), Amazon (AMZN) or Tesla Motors (TSLA).

That potential has to exist. Otherwise, why bother with the stock? For that simple reason, trend analysis is critical when researching small-cap stocks. There are different types of trends investors can focus on: macro-economic trends, industry growth trends, company-specific trends in revenue, earnings, product cycle … the list goes on.

But right now I’m talking about big picture thinking, which means industry growth trends. In Cabot Small-Cap Confidential 2.0, we even have a section of each report dedicated to it called “The Big Idea.”

The rationale for detailing the Big Idea is simple: a big growth trend raises the odds of big small-cap stock gains!

Side Note: The Big Idea, or industry trend analysis, falls into the bucket of “top down” analysis (this distinction is for those of you who, like me, like to put forms of stock analysis into different buckets). The opposite of top down analysis is “bottom up” analysis, which focuses more on company-specific trends. This is important in selecting the right stock to play the trend, and a good portion of each stock report I publish is dedicated to bottom up analysis too.

As Merrill Lynch’s ad from 1971 shows, trend-based investment strategies are not new. But they can be extremely successful—and an excellent tool for communicating the potential with clients.

If Charlie Merrill were around today and working on the next advertising campaign, I know what trends and which stocks I’d bring to the meeting with the advertising execs. All three are stocks I’ve selected for Cabot Small-Cap Confidential 2.0, and all three are currently showing double-digit gains for my subscribers. Each is poised to keep rising as their respective growth trends power on.

The first company is growing revenue by more than 30% from a little known trend I call “the great vending machine upgrade.” The company makes point-of-sale hardware for vending machines that allows them to take cards, as well as electronic payments, including Apple Pay, Android Pay and Chase Wallet. Even better, 75% of revenue comes from connected services that help vending machine operators generate more money from each machine. Think of on-screen advertising campaigns and real-time vending machine performance metrics. This trend isn’t discussed in The Wall Street Journal. But it’s very real, and very profitable.

The second company is growing earnings by over 100% from a well-known trend—growth in bottled water. Bottled water is set to become the No. 1 beverage by volume in 2017, if not by the end of 2016. And this small company is right in the middle of the movement, selling bulk water to households across North America.

The third company is a targeted way to play explosive growth in virtual banking. It sells cloud-based software solutions to small banks and credit unions, many of which are upgrading their technology to fulfill their missions as customer-driven organizations and to compete with the big banks. Revenue growth is well over 30%, and there are years and years of rapid growth ahead of this company.

All three of these small-cap stocks are outperforming the broad market, and even the small-cap stock index, which is up almost 10% year-to-date. I think they’ll continue to do so in the years ahead.

You can click here now to begin a subscription to Cabot Small-Cap Confidential, and get all the details on each of these three stocks, not to mention all the other high-potential small-cap stocks I cover. Each report features analysis of the Big Idea behind each stock. And I think each stock has a good chance to lead the market in the months ahead.

Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.