Stocks to Watch: Small-Cap Companies Buffett Would Love

By Markets Fool.com

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One of the most important lessons I ever learned as an investor was to keep an active watchlist. Over time, I've populated it with businesses I really like that trade at prices I really dislike. But markets are always changing, and so are stock prices. Opportunity will come in due time.

Today I'd like to share two small-cap stocks with businesses that are both understandable and durable, but trade at prices I personally deem too high. Both businesses have traits Buffett would love: durable brands, strong competitive positions, and low-cost advantages. If Mr. Market gives me a deal, I'll be buying shares of each with both hands.

1. WD-40 Company
WD-40 Company is everything Buffett likes in a company, and a little more. It's best known for its brand of penetrating lubricants, which it sells in familiar blue, yellow, and red cans in retailers around the world.

It's difficult to overstate the brand value of the WD-40 name. In 1993, one study estimated that WD-40 could be found in 81% of American households. To put that in perspective, in the same year, WD-40 would have been more popular than air conditioning (68% of homes) and slightly less popular than dishwashers (82% of homes). It's unlikely things have changed much; WD-40 is a product virtually every American has used before.

Its lubricants carry the bulk of its sales, but it has a few other brands in its stable, including familiar names like Spot Shot cleaner, Lava soap, and 2000 Flushes toilet bowl cleaner. The company breaks out its sales by product type, putting products into two categories: Multi-purpose maintenance products (includes WD-40 and 3-in-1, which made up 88% of sales) and Homecare and cleaning products (which includes its non-oil based products and made up 12% of sales).

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Beyond the brand's intangible value, I have to think Buffet would also like its capital-light business model. The company contracts out its manufacturing, shifting the capital intensive part of the business off its balance sheet. Thus, the company correctly describes itself as more of a marketer than a product manufacturer.

For all of the good behind WD-40, I think it's important to recognize it never truly trades cheaply, and it's in an industry with already-inflated multiples. It trades at about 28 times earnings and 40 times free cash flow, well above the 23 times average earnings multiple of a leading consumer staples index.

I'm not convinced it will always be so expensive, however. In 2008, investors let it go for about 10 times that year's earnings, a very compelling price for a quality brand. At that price, I couldn't say no, and thus it has remained on my watchlist for several years running.

2. Bank of Hawaii
Buffett and Munger have both opined that Wells Fargois the investment by which they judge all others, a testament to their love for a well-run institution. I can't help but think you'll find much of what Buffett likes in Wells Fargo in small-cap company Bank of Hawaii.

Bank of Hawaii is a regional bank that operates primarily in the state of Hawaii, and to a smaller extent in Guam and Saipan. In Hawaii, it's part of a powerful duopoly that controls the majority of deposits. Privately held First Hawaiian Bank claims 35.6% of deposit market share; Bank of Hawaii's share stands at 32.8%. (The third-largest bank, American Savings Bank, holds just 12.5% of the market and will soon go public. It, too, may deserve a look when its shares trade publicly.)

The competitive dynamics of Hawaiian banking heavily favor the larger institutions, which have more deposits per branch, thus earning a low-cost advantage. In addition, a bigger balance sheet means the two largest institutions are the only competitors for the state's largest local borrowers.

A tight real estate supply keeps land and buildings perennially pricy, and a constant supply of tourists and retirees bring wealth by the day. Loan losses have been minimal. Its net charge-offs peaked at just 1.43% of its average loans and leases in 2009. In 2014, charge-offs registered at a microscopic 0.03% of its average loans and leases.

In addition, the bank benefits from substantial noninterest income, which made up roughly 32% of its net revenue in 2014. Service charges on its accounts, other fees (like currency exchange), and asset management revenue made up the majority of its revenue.

One thing is certain: The market is cognizant of Bank of Hawaii's enviable competitive position. Shares trade at roughly 2.8 times tangible book value and 17 times last year's earnings. Given its size, it's unlikely Bank of Hawaii can grow much faster than the Hawaiian economy as a whole. And it has a habit of paying out roughly 50% of its income out as a dividend, in addition to frequent share purchases.

Buying here might net you a 10% return over the very long haul on back-of-the-envelope calculations, but patient investors will likely get a chance to buy it cheaper. In a market decline, cyclical stocks like banks take the brunt, good or bad. That may spell opportunity for the nimble investor to buy a top-performing bank at a bottom-barrel price.

The article Stocks to Watch: Small-Cap Companies Buffett Would Love originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of Hawaii and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.