A journey of 1,000 miles starts with 10 stocks. After many weeks of screening potential candidates for the inaugural Roadrunner Stocks portfolios, I’ve finalized the list of 10 that we’ll start with. But before I give you the details on each, I offer you a quick explanation of how this website and issues are structured. 

For starters, there are two portfolios: Momentum and Value. They are included in the monthly issue PDF, but they may also be viewed on the Roadrunner Stocks website, via the home page or top navigation menu. Once on a portfolio page, you may click on any stock name to see its underlying Stock Spotlight report.

Spotlights are essentially an executive summary of why I’m recommending each stock. These are reviewed and updated several times during the year or as news dictates. For this inaugural issue, I am also including each Spotlight report below.

In subsequent months, this article space will be used to just provide quick updates on each portfolio holding. Any urgent updates will, of course, be immediately emailed to you as a Flash Alert. Alerts typically occur only when I’ve made a change to my Buy/Sell/Hold advice on a stock or if major news events occur.

The other two components of your monthly issue are Frontrunners and The Roadmap. I will add one stock to each of the portfolios every month and profile each as a longer Frontrunners article. The Roadmap will be a macro view of small cap stocks and an ongoing plan to help you profit from this exciting universe of value and growth stocks.

Here’s the list of stocks highlighted in our first Portfolio Update, plus the Stock Spotlight report for each. The first four are from my Special Report, Small Cap Wealth-Builders, which you may have read already. The next two are the subject of this month’s Frontrunners article. And the last four are new portfolio additions that I may discuss further in future issues.

Gentex (Nasdaq: GNTX)
Carbo Ceramics (NYSE: CRR)
PriceSmart (Nasdaq: PSMT)
HMS Holdings (Nasdaq: HMSY)
Diamond Hill Investment Group (Nasdaq: DHIL)
SolarWinds (NYSE: SWI)
Buckle (NYSE: BKE)
United Therapeutics (Nasdaq: UTHR)
Ocwen Financial (NYSE: OCN)
Western Refining (NYSE: WNR)

Value Play — Gentex (Nasdaq: GNTX)

Have you ever been driving your car at night and had someone tailgate you with their car’s bright headlights on and almost blind you? It’s a real safety hazard. The solution is to install rearview mirrors with automatic-dimming capability, so that the mirror becomes tinted when it senses bright headlights coming your way.

Gentex has a virtual monopoly on automatic-dimming car mirrors (87.9 percent market share). Right now, these high-tech mirrors are only installed in 23 percent of cars worldwide (45 percent to 50 percent in North America), but Michigan-based Gentex sees the global percentage increasing to 45 percent over the next decade, which would mean $3 billion in additional revenue. Since the company’s entire market cap right now is only $2.6 billion, the prospects for stock-price appreciation are tremendous.

The company is a true value stock, trading at only 16 times earnings when its historical five-year average multiple is closer to 26. The stock is depressed because 45 percent of mirror unit shipments go to Europe, which is in the depths of a deep recession.  But the company continues to grow revenues and earnings regardless of the economic climate.

Over the past 25 years, it has achieved 19.7 percent compounded annual revenue growth and over the past three years, the average annual revenue and earnings growth has been equally stellar at 18.0 percent and 37.4 percent, respectively. Growth should accelerate in the future as the population ages because older people have much more difficulty handling glare and therefore need mirror-dimmers more than younger folk.

An added kicker involves the imminent release by the National Highway Traffic Safety Administration (NHTSA) of rules mandating the use of rear-camera displays (RCDs) in all cars. Many children die or are gravely injured by motorists who can’t see them while backing up. Gentex already produces a version of its rearview mirrors with RCD capability, so it could be a prime beneficiary of the new rules.

However, some car manufacturers have stated their preference for RCD to be housed in the console and not in the mirror. This doesn’t make sense to me since drivers have always been conditioned to look in the rearview mirror when backing up. Looking at the car console instead is unnatural, which means they’ll often forget and continue to cause accidents. I’m betting on the Gentex approach to win out.

Other growth drivers include the SmartBeam Headlamp Assist System, which automatically decides whether a car’s headlamps should be on regular or bright power. Whenever the system senses a car in front, the headlamps are lowered to regular and then raised back to brights when there are no cars in front anymore. This system saves lives in two ways, first by reducing the blinding glare of bright lights in traffic, and second by improving nighttime visibility with brights when no other cars are present.

I’m not worried about competition because Gentex is always innovating to stay on top, spending 8 percent of sales on research and development, which is three times more than the average auto-parts manufacturer. Now is the time to jump into the stock while it is unnaturally cheap. Once the European economic rebound becomes widespread and public, the stock will most likely return to a 26 priceot-earnings (P/E) multiple. With current earnings per share (EPS) of $1.17, that would mean a stock price of $30—more than 60 percent higher than the current level.

Value Play — Carbo Ceramics (NYSE: CRR)

Carbo Ceramics is the world’s largest manufacturer of ceramic proppant, used during the hydraulic fracturing process to “prop” open the cracks while simultaneously being highly conductive and permeable so that the oil and gas can easily escape to the surface.

Ceramic is more expensive than sand as a proppant, but ceramics are also much more effective, increasing oil well productivity by 20 percent to 50 percent. Ceramics are currently 20 percent of the proppant market and market share is increasing along with overall proppant growth.

Carbo Ceramics is also the owner of Falcon Technologies, which is the leading supplier of spill prevention and containment systems for the oil and gas industry. This is important given the recent Wall Street Journal report that water contamination is caused by poorly sealed wells and not fracking.

The company has been profitable for 25 consecutive years, with compound annual growth of 20 percent during that entire period. In July 2012, the stock’s dividend was raised for the 12th consecutive year despite an industry downturn. Bottom line: Carbo Ceramics is a well-run company with consistently excellent financial performance and no debt.

CEO Gary Kolstad is an oil services veteran whose experience includes 20 years working for Schlumberger. Carbo Ceramics stock lost 65 percent of its value between July 2011 and October 2012 because of an industry-wide downturn in North American drilling activity in the face of plunging natural gas prices, combined with logistical difficulties transporting proppant to oil shale instead of gas shale regions. Weak natural gas prices caused drillers to switch temporarily to lower-quality Chinese proppant.

Long term, the switch to oil shale is good for Carbo Ceramics because high-quality proppant is even more beneficial for oil shale than it is for natural gas shale. CRR recently reported third-quarter earnings that were better than analyst estimates. CEO Gary Kolstad eased investor concerns about Chinese proppant competition when he stated:

We continue to see strong ceramic proppant sales volumes in the active major shale plays such as the Eagle Ford, Permian and Bakken. One reason for this strength is that several clients appear to be replacing lower quality, lower conductivity Chinese Intermediate Density Ceramic (IDC) proppant with our high quality, high conductivity lightweight ceramic proppant.

With the company’s transition to oil shale almost complete, and oil prices expected to remain stable in 2013, the future appears very bright for this best-of-breed energy-service company. Valuation is very reasonable at 15.9 times trailing earnings, 30 percent lower than the company’s historical five-year average P/E of 22.4. CEO Kolstad has taken notice of the company’s cheap price; in November, he purchased 2,500 shares at an average price near $75.

Momentum Play — PriceSmart (Nasdaq: PSMT)

The largest operator of membership warehouse clubs in Central America, South America and the Caribbean, PriceSmart serves over 1 million cardholders at 30 warehouse clubs in 12 countries and the U.S. Virgin Islands.  PriceSmart isn’t just a Costco wannabe imitator, it was actually spun off from Costco (then called Price/Costco) in 1994 and former Price/Costco Chairman of the Board Robert Price has been PriceSmart’s Chairman of the Board ever since the 1994 spinoff.

In other words, PriceSmart is immersed in Costco’s business culture because it is run by former Costco management. If PriceSmart can mimic Costco’s success in Latin America, the stock will be a homerun over the next decade. The market capitalization of PriceSmart’s stock is currently $2.2 billion, whereas Costco’s is $44.1 billion. I’m not saying that PriceSmart will grow 20 times in value to equal Costco’s market cap, but even a fraction of that catch-up growth will make current investors rich.

In the October 2012 conference call discussing full-year 2012 financial results, CEO Jose Laparte stated:

“As a company we are pleased to report that we accomplished a milestone with our sales results of $2 billion. It was only four years ago in fiscal year 2008 that we passed the $1 billion milestone and now in 2012 we were able to double that number of sales. Back in 2008, our average sales per club was $40 million and this past fiscal year the average sales per club is at $68.9 million.

In terms of membership, we finished the year with more than 965,000 accounts and membership income of $27 million, an increase of 18 percent compared to fiscal year 2011. During the fourth quarter, on June 1, we raised our membership fee in 10 of our countries after eight years of no adjustment in fees. In US dollars, we moved it from $30 to $35. The annual membership fees are a fundamental part of our business model and are applied to margin as a way of reducing prices on merchandise.”

PriceSmart is a very profitable company and has been for several years. Its return on invested capital of 14.3 percent is higher than Costco’s 12.8 percent and its five-year annual sales and earnings growth has averaged 18.2 percent and 38.5 percent, respectively. Valuation isn’t cheap at 33 times trailing earnings, but this valuation simply reflects the tremendous growth potential of the company in Latin America.

PriceSmart continues to expand in Central America (Columbia is the current expansion target), and is introducing the more-advanced $75-per-year “Platinum Card” concept in its largest market of Costa Rica. But the real breakthrough growth will occur when it decides to enter the Brazilian marketplace—the largest marketplace in all of Latin America.

Momentum Play — HMS Holdings (Nasdaq: HMSY)

With President Obama’s re-election in November and the US Supreme Court’s earlier decision upholding The Patient Protection and Affordable Care Act (PPACA), “Obamacare” is now entrenched as the law of the land. This sweeping legislation will transform America’s $2.7 trillion-a-year health care industry for years to come.

More than 30 million Americans who are currently uninsured will become insured under Obamacare.  The vast majority of these newly insured will be consuming health services that are government subsidized. That means big increases in government health care spending and big challenges for those government administrators who are responsible for both making sure health care providers are properly reimbursed and that health care spending does not spiral out of control.

Enter HMS Holdings, which characterizes its business as “payment integrity.” Payment integrity has two functions:

1. Coordination of benefits to ensure that health claims are paid by the responsible party, whether it be the insurer or the individual patient.
2. Fraud prevention to make sure that claims are paid accurately and for actual services rendered.

HMS has been helping government agencies and corporations save money since 1974. In 2009, the CBS newsmagazine 60 Minutes called Medicare fraud “one of the most profitable crimes in America.” The market opportunity over the next decade is immense. By 2015, HMS estimates that the U.S. government will spend $1.3 trillion annually on Medicaid and Medicare and $107 billion of this spending will be either waste or fraud (8.3 percent).

Historically, Medicaid has been the company’s bread-and-butter business and the PPACA requires each state to hire a Medicaid Recovery Audit Contractor (RAC). HMS subsidiary HealthDataInsights has already been appointed the RAC contractor in Region D of the U.S., which covers 17 upper-Midwest and Western states, as well as three territories. HMS has also been assigned RAC work in four other states outside of Region D for a total of 21 states.

Non-governmental commercial health insurance will potentially suffer an additional $53 billion in unnecessary costs for a total market opportunity of $160 billion. In 2011 alone, HMS clients recovered over $2.5 billion, and saved nearly $7 billion through the prevention of erroneous payments.  Comparing the future $160 billion market opportunity with HMS’s current $9.5 billion business underscores the tremendous growth HMS will experience in the years ahead.

HMS Holdings is a very profitable company and has been for several years. Five-year annual sales and earnings growth has averaged 32.8 percent and 49.6 percent, respectively, which explains why the company is ranked 28^th in Forbes Magazine’s 2012 of the “Best Small Companies in America.” The stock isn’t cheap at 50 times trailing earnings, but it historically has traded at similarly-high multiples and the tremendous growth opportunity under Obamacare justifies its current valuation and then some.

Value Play — Diamond Hill Investment Group (Nasdaq: DHIL)

Diamond Hill Capital Management is a Columbus, Ohio-based registered investment advisor and its stock is a member of the Russell 2000 small-cap index.

Diamond Hill manages a fixed income, five long-only equity and three alternative-equity strategies. Its client base includes institutions, financial intermediaries as well as high net-worth individuals.

The majority of the company’s capital is invested using a proprietary valuation model similar in nature to the investing styles of Benjamin Graham and Warren Buffett.

Diamond Hill has no debt, increasing assets under management (to roughly $9.4 billion). The company also boasts five consecutive years of special dividends equaling a minimum annual yield of 7 percent and a strong return on invested capital (ROIC) of more than 40 percent.

The firm’s return on assets (ROA) and return on equity (ROE) are in the high double digits. These indicators measure the efficiency of management and how well management is able to leverage assets and reinvest past profits for future growth.

Management’s interests are aligned with shareholders’ interests. Management and insiders now own over 30 percent of the company, which is double what it was 10 years ago when a private placement of stock was issued to employees giving them more incentive in the form of ownership to produce better results.

Since giving management some equity ownership of the company from 2004-2013, the stock is up over 3,000 percent (over 44 percent annualized). However, for the past three years the company has struggled and underperformed its expectations. Nevertheless, assets under management (AUM) continue to flow into the company’s coffers, which demonstrates the confidence long-term investors still have in Diamond Hill’s value- oriented investing approach, betting on the company’s outstanding track record.

While waiting for a performance turnaround, investors are likely to continue to receive annual special dividends which have totaled $46 per share over the past five years. Not bad for a stock trading at $70.

Momentum Play — SolarWinds (NYSE: SWI)

SolarWinds delivers powerful and affordable IT management and monitoring software to over 100,000 customers worldwide—from Global 1000 enterprises to small businesses.

The company’s product and service offerings range from individual software tools to more comprehensive software products meant to solve problems faced every day by IT professionals.

SolarWinds has a disruptive and highly-efficient business model that enables it to take business away from much-bigger competitors by offering products at up to a 90 percent discount.

Its “Dell-like” sales distribution model allows it to grow rapidly and gain market share without massive amounts of capital and to maintain high operating margins in a large—roughly $270 billion in sales per year—and growing IT marketplace.

Although most of its competitors generate about 56 percent of their total revenues from outside of the US, SolarWinds only generates slightly above 20 percent of its revenue from non-US sources. There is a lot of room for the firm to grow sales outside the US and the company plans to double its share of international sales.

SolarWinds has no costly exterior sales force and doesn’t cold call potential clients. Instead, its marketing efforts are demand driven and web-based. This means they only reach out to customers after these customers have already manifested interest through a Google search or some similar affirmative action. The company’s thwack.com social networking website for IT professionals encourages clients to stick around for repeat business, as well as purchase recurring annual maintenance services (one of the strongest growth drivers right now).

Management has been very careful not to grow too quickly by taking on massive debt and has made small acquisitions that can be absorbed quickly to maintain a strong balance sheet.

With a forward P/E ratio of roughly 30, the stock is pricey but its disruptive business model and strong sales and earnings growth justify the valuation.

Value Play — Buckle (NYSE: BKE)

Buckle is headquar­tered in Nebraska and operates 440 ap­parel stores in 43 states, focusing on jeans (40 percent of sales) and tops (30 percent of sales) for those aged 15 to 30 years, including both women (55 percent of sales) and men (45 percent of sales). Unlike its competitors, Buckle expands its store count slowly by only 4 percent to 5 percent per year, which ensures that the company operates profitable stores and has plenty of free cash flow for dividends.

Chairman of the Board Daniel Hirschfeld and CEO Dennis Nel­son collectively own 40 percent of the company’s stock. Therefore, manage­ment’s financial incentives are aligned with the average shareholder.

The company pays an 80-cent regular annual dividend, and has added a special dividend of at least $2 in each of the five years since October 2008. The stock’s total dividend yield is near 7 percent, which is much higher than most apparel stocks.

Buckle is extremely profitable with the highest operating margin in the ap­parel industry, returns on invested capital of almost 40 percent, and annual EPS growth of almost 15 percent over the past ten years. 

Did I mention that it has zero debt?

The stock also has a low beta of 0.86 based on the fact that demand for new apparel among teens is much less sensitive to economic conditions than it is for adult women.

Value Play — United Therapeutics (Nasdaq: UTHR)

United Therapeutics focuses on the treatment of a relatively rare disease called pulmonary arterial hypertension (PAH). The 250,000 people worldwide who suffer from PAH have high blood pressure in the arteries of their lungs. When the small arteries of the lung narrow, they can’t carry as much blood and pressure builds. This pressure forces the heart to work harder to push the blood through the arteries, leading to heart damage.

The global market for PAH treatment is roughly $4 billion in annual sales and United Therapeutics currently has about a 15 percent overall market share. However, United Therapeutics is the market leader in treating severe PAH, with its Remodulin brand controlling 80 percent of the market compared to a 20 percent combined market share for Gilead Sciences’ Flolan brand, Swiss-based Actelion’s Veletri brand, and a generic version of Flonan made by Teva.

Drugs for severe PAH have to be administered either through intravenous injection (IV) or pumped under the skin (subcutaneous). Annual drug treatment costs for severe PAH can run upwards of $90,000 per year; United Therapeutics is a very profitable company despite serving a small patient base.

More moderate cases of PAH can be treated with an inhaled version of United Therapeutics’ Remodulin called Tyvaso, which competes against a Bayer AG drug called Ventavis.

Lastly, the mildest forms of PAH can be treated with oral pills, including United Therapeutics’ Adcirca, which is a more potent form of Eli Lilly’s (NYSE: LLY) Cialis, and Pfizer’s (NYSE: PFE) Revatio, a more potent form of Viagra.

Oral Remodulin would be the drug of choice for tens of thousands of moderate to severe PAH sufferers who have not been helped by the less-effective drugs Adcirca and Revatio that are based on the erectile dysfunction compounds. But so far, test results of oral remodulin have been inconclusive as to effectiveness. If the US Food and Drug Administration were to approve oral remodulin, the stock would soar.

The problem with many biotech companies is that they burn cash and have no revenue or profits; all of their stock value is based on speculation that the drugs in their testing pipeline will get to market and generate cash. United Therapeutics is different, having generated 25 percent compounded annual revenue growth–all organic and not based on acquisitions—for ten consecutive years. It sells for only 10 times earnings, has almost $10 per share in cash, and last year earned a solid $3.67 per share in earnings. CEO Martine Rothblatt has been buying tens of thousands of shares over the past year.

Momentum Play – Ocwen Financial (NYSE: OCN)

Ocwen Financial is the fifth-largest U.S. mortgage servicer of residential and commercial loans. More importantly, it is the market leader in servicing high-risk mortgage loans. The company has been active in the residential mortgage market since its founding in 1988, but it really came into its own during the 2008 subprime mortgage crisis. Unlike most mortgage companies that hate non-performing loans, Ocwen loves them because it has an unparalleled ability to convert them back into re-performing loans for a profit:

Source: Q3 2012 Earnings Conference Call Slides

Over its 20 years in business, Ocwen has spent more than $150 million researching and developing proprietary analytical software based on best-in-class data collection, artificial intelligence, psychological profiles, and resolution models—all for the sole purpose of increasing the probability that deadbeat property owners will pay back the money owed on their mortgages. Ocwen Chairman William Erbey was quoted saying: “We have as many social psychologies as most universities with psychology departments.”

The mortgage servicing industry continues to consolidate as large money-center banks overburdened with non-performing loans seek to outsource their servicing responsibilities. Ocwen is more than glad to help, buying up as many mortgage servicing rights (MSRs) as the banks will sell them. In 2010, Ocwen disrupted the servicing industry with its Shared Appreciation Modification (SAM) loan program.

This innovative SAM loan modification significantly reduces default rates by writing down mortgage principal to 95 percent of the home’s current market value so that homeowners are no longer underwater on the loan (borrowers who are underwater owe more than their houses are worth and thus have a strong incentive to default and walk away.

Giving mortgage borrowers a 5 percent equity stake incents them to stay current on their loan payments. In return, the borrowers agree to transfer to the lender 75 percent of any home price appreciation that occurs between the date of the loan and the date when the house is sold. A win-win for everyone involved, resulting in fewer foreclosures and redefault rates below 3 percent.

Third-quarter financial results saw record revenues and operating income and full-year 2012 earnings per share are forecast to rise 36 percent to $1.43. But 2013 is shaping up to a year of even better results—much better results. Get this: Earnings per share are forecast to skyrocket 212 percent to $4.46 and revenues to double.

If those projected numbers pan out, then Ocwen’s share price could double again in 2013 after more than doubling in 2012. The smart money appears to be holding fast for more good times, with best-performing mutual funds buying the stock during the fourth quarter of 2012 and Ocwen insiders maintaining an ownership stake above 19 percent of shares outstanding (page 13).

Momentum Play – Western Refining (NYSE: WNR)

Refiners make their money off of the “crack spread,” which is the difference between the input cost of crude oil and the output revenue from refined products like gasoline and heating oil. The standard formula says that three barrels of crude oil can be converted into two barrels of gasoline and one barrel of heating oil.

U.S. refiners are currently in a “sweet spot” because there is a supply glut of West Texas Intermediate (WTI) crude oil at both the Cushing Oklahoma and Midland Texas storage terminals. This glut is caused both by increased North American oil production – thanks both to Canadian oil sands and US oil fracking—and a shortage/bottleneck of pipelines needed to transport the oil from the Cushing and Midland storage terminals to refineries on the Gulf Coast. 

Western Refining is a small company with only two refineries—a large one in El Paso, Texas (128,000 barrels per day) and a smaller one in Gallup, New Mexico (23,000 bpd). What it lacks in size it makes up for in perfect positioning.

Both of its refineries have direct access to WTI crude oil production in the Permian Basin which is stored at the Midland terminal. Midland WTI is cheaper than Cushing WTI ($2 less now but it was $20 less in November 2012 and $12.51 less in December), and both are currently more than $16 per barrel cheaper than Brent North Sea crude oil. Furthermore, Western sells its refined products throughout the Southwest, which is part of the West Coast market that commands higher retail pricing than the East Coast because transportation costs make European refined imports uncompetitive out West. This situation is the best of both worlds—low input costs and high output revenues!

Near-term catalysts include a potential spinoff of pipeline and gathering systems into a tax-advantaged master limited partnership (MLP) in mid-2013 and the refinancing of $300 million in high-cost (11.25 percent) debt that could reduce borrowing costs by 500 basis points.

The company is committed to returning cash flow to shareholders, having announced a $200 million share repurchase program in July 2012, paying out two special dividends totaling $2.50 per share in late 2012, and recently increasing its regular quarterly dividend by 50 percent year-over-year. As CEO Jeff Stevens said recently:

“Our margin environment continues to be very strong. The Permian Basin crude oil discount significantly widened in December and continues to widen into 2013. This environment, coupled with our aggressive debt reduction, conservative capital structure, and ongoing hedging initiative, allows the Company to continue to return cash to shareholders via dividends and our share repurchase program.”

Western Refining rose 112 percent in 2012 and I see the good times continuing well into 2013. Although the supply glut of crude at the Midland terminal has lessened recently, the risk of the glut widening again remains with ever-increasing U.S. oil production. Insiders own 32 percent of the company and have strong financial incentives to keep the profits gushing.