3 small cap favorites for 2013

by Richard Moroney, editor Upside Stocks

Our Best Buy List is diversified by sector, and its style is slanted toward modestly valued growers. We want to be in the best stocks possible at a tolerable level of risk.

This focused approach has paid dividends, with the Best Buy List up 320.8% since its May 1999 inception excluding dividends and transaction costs, versus 84.4% for the Russell 2000 and 8.0% for the S&P 500. In reviewing this portfolio, here are four of our top picks for 2013.

The oldest maker of slot machines in the world, Bally Technologies (BYI) is well positioned for growth. Besides gaming devices, Bally sells software licenses for managing data, tracking players, and protecting against fraud.

Many of these products are sold under multi-year contracts, providing the company with a high amount of recurring revenue — and providing management with the confidence to leverage its balance sheet to fund internal investments, make acquisitions, or repurchase shares.

Bally has bought back 25% of its share count in the past two years. Total debt is $557 million, up from $164 million in March 2011, but interest expense is still well covered by operating cash flow and earnings.

Bally has delivered five straight quarters of double-digit sales growth while steadily expanding its operating profit margins. Cash provided by operations rose 33% in the past year.

For fiscal 2013 ending June, Wall Street targets per-share earnings of $3.26, up 33% on a 10% revenue gain. Bally, capable of climbing 20% over the next year, is rated Best Buy.

Cardinal Financial (CFNL) scores at least 90 for five of six Quadrix categories and earns a maximum Overall rank of 100. The regional bank serves the Washington, D.C., area, one of the nation’s strongest labor markets.

Robust activity from mortgage refinancing drove Cardinal’s 31% revenue gain in the first nine months of 2012. Deposits advanced 21% in the September quarter, while loans increased 16% on strong growth in real-estate construction.

The stock looks cheap at 11 times trailing earnings, 33% below its three-year average and 20% below the median for regional banks in the S&P 1500 Index.

Washington’s healthy housing market bodes well for Cardinal’s mortgage-banking business. Rising consensus estimates project growth in per-share profits of 50% in the December quarter and 39% in the March quarter. Cardinal is a Best Buy.

Triumph (TGI) has seen operating income jump 34% in the past year on 7% sales growth. Credit for the improved profitability primarily goes to the aerostructures unit, which builds aircraft wings, fuselage sections, flight-control surfaces, and helicopter cabins.

The unit has improved commercial production rates and reaped cost synergies from a $407 million acquisition made in June 2010. Management sees opportunities to expand profit margins further.

Triumph seems well positioned in an improving commercial-plane market. In the military market, likely to be affected by U.S. budget constraints, Triumph believes it can gain share.

Triumph shares trade at 11 times trailing earnings — 16% below their three-year historical norm and 13% below the median for aerospace stocks in the S&P 1500.

Management says it will consider increasing the dividend, currently at $0.04 per share, or even pay a special distribution, if it fails to find attractive acquisitions. Triumph is a Best Buy.

Learn more about this financial newsletter at Richard Moroney's Upside Stocks.

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