"The prospect of earning a premium for investing in small-cap companies is compelling," said Karen Wallace, senior editor at Morningstar.com, who discussed in a recent report the merits of investing in small-caps with wide "economic moats," or structural barriers that that help protect companies from competition.
She said the so-called small-firm effect argues that companies with smaller market capitalizations "tend to outperform the market as a whole."
Wallace pointed out that in 2015, AQR Capital conducted a study that showed the key to harnessing small-cap outperformance is to focus on "quality firms" that have demonstrated consistent profitability growth and solid balance sheets. In other words, no "junky" companies.
Wallace noted that the cornerstone of Morningstar equity analysis involves identifying wide moats that are synonymous with quality -- companies whose returns on invested capital are likely to exceed their weighted average cost of capital in the future. "We also look for firms that appear to have at least one of the five sources of sustainable competitive advantage: intangible assets, cost advantage, switching costs, network effect or efficient scale," she said.
Wallace has identified nine small-cap companies with wide economic moats that will allow them to be profitable for at least 20 years.
And three of them appear to be particularly attractive, according to some investors and analysts: Dun & Bradstreet (DNB), John Wiley & Sons (JW.A) and Blackbaud (BLKB).
Dun & Bradstreet, a leading global provider of business information and related decision-support services, has yet to participate in 2017's robust advance. Its stock is trading at $109 a share, down nearly 10 percent this year and well below its 52-week high of $141.57. However, the stock sharp's decline is attracting some opportunistic investors, who expect the company to post higher earnings in 2017. Some analysts see DNB beating earnings expectations when it reports its first-quarter results on Monday, May 1.
Catherine Seifert, equity analyst at CFRA Research, upgraded the stock in November to "hold" from "sell," based on valuation. She noted that DNB's new products and services, such as a business-to-business online supplier database with information on importers and exporters of specific products worldwide, "will likely help longer-term growth." However, she also noted that DNB faces competitive and currency headwinds.
John Wiley, which provides knowledge-related services in the areas of research, professional practice and education worldwide, also hasn't participated in the market's advance this year. It's trading at $53 a share, not far from its 52-year high of $58.86, and some big investors see it exceeding that mark this year. So far, according to CFRA's analysis of the stock's fair value, John Wiley is undervalued.
The company's research segment offers scientific, technical, medical and scholarly studies and journals that serve scientists, engineers and technologists in the academic, government and public sectors.
Blackbaud, which provides cloud software services to nonprofits, foundations, health care groups, various charities and other organizations, has been a strong winner since October 2016, when it was trading at around $55. It closed on Friday at $80.41, which exceeded its previous 52-week high of $79.28. It actually touched $81 during Friday trading, setting a new 52-week high at that level.
The company's strength is in helping private organizations increase their impact with software in digital marketing, grant management and improving corporate social responsibility.
Even though Blackbaud's earnings and revenues have been on the rise since 2012, the company has yet to attract wide attention on Wall Street.
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