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3 Small-Cap Stocks With Large-Cap Potential

Individual investors have a key advantage compared to their institutional counterparts -- their opportunity set is much larger. Investing in small-cap stocks, which have market capitalizations between $300 million and $2 billion, can be lucrative for those willing to look where most of the market isn't. With patience and a long-term time horizon, some of these companies have the ability to grow into large-cap stocks and achieve a valuation that exceeds $10 billion.

I think Digital Turbine (NASDAQ: APPS), Macerich (NYSE: MAC), and Trupanion (NASDAQ: TRUP) all possess qualities that could propel them from small-cap status into the big-cap club.

1. Digital Turbine ($1.4 billion)

Digital Turbine is a platform business that works with wireless carriers and cellphone manufacturers to preinstall applications on new devices, and then sells these application slots to large app-driven companies such as Amazon and Netflix. The company generates revenue for every installation, and, in some cases, when the app is opened on a device.

Digital Turbine's success ultimately depends on the number of Android phones it controls and the revenue per device. With global penetration currently on fewer than 10% of Android smartphones, Digital Turbine faces a large market opportunity. Furthermore, a new partnership with Samsung will materially bolster revenue in coming years.

Series of upward arrows with man in suit touching one

Image source: Getty Images.

From fiscal 2016 through fiscal 2020 (the company's fiscal year ends in March), revenue soared at a compound annual growth rate (CAGR) of 58%. After recording a net loss in 2016 that was greater than its revenue that year, Digital Turbine generated $14.3 million in profits in 2020. Investors will find it extremely appealing that a rising company like this has already achieved profitability and has a solid growth runway ahead.

While the coronavirus pandemic and ensuing recession will clearly hurt new cellphone sales and extend upgrade cycles in the near term, the longer-term secular tailwind is still in place. People love having a device in their hands, and advertisers and application-driven companies will continue wanting to reach them.

The stock is up 118% so far this year through Tuesday's close, and with a price-to-earnings (P/E) ratio just short of 100, it does not appear cheap by traditional valuation metrics. However, incredible revenue growth, improving margins, and a long runway ahead all make Digital Turbine an attractive investment.

2. Macerich ($1.2 billion)

Macerich is a real estate investment trust (REIT) that is involved in the acquisition, management, and leasing of shopping centers throughout the United States, with a primary presence on the West Coast, Arizona, Chicago, and the New York to Washington, D.C. corridor. As of March 31, the company had an ownership interest in 52 locations totaling approximately 51 million square feet of leasable space.

Given that Macerich generates most of its revenue from leasing, it's not surprising that the coronavirus pandemic has had a severe negative effect, as its tenants were forced to close their doors starting in March. And with brick-and-mortar retail in a secular decline, you must be wondering why I'm recommending this stock.

Macerich's strength lies in its tenant quality, which includes names like Apple, lululemon athletica, and Tesla, as well as attractive dining and entertainment options, and even coworking spaces. Additionally, a major component of the company's growth strategy involves redevelopment of older department store boxes into newer mixed-use projects.

Over the past five years, portfolio occupancy rates have stood at 94% or above. And from 2016 to 2019, dividends and sales per square foot have increased each year. These numbers are quite impressive by any measure, and demonstrate the quality of Macerich's portfolio. But at the end of Q1, which includes the first few weeks of coronavirus stay-at-home orders, occupancy was down less than 1% from the prior quarter, and management has chosen to pay 80% of its dividend in stock to preserve cash.  

The most important factor for Macerich to focus on in the near term is its liquidity in order to survive the adverse economic climate. During the first quarter, the company took measures to strengthen its financial position, which included drawing on its existing line of credit, lowering its dividend as previously mentioned, and reducing its development pipeline for 2020.

REITs are valued based on their funds from operations (FFO), a measure of its cash flow that adds back depreciation and amortization charges and subtracts any gains on property sales. This measure is used to get a true picture of operating performance. As of Tuesday's close, Macerich trades at a little over 2 times its trailing-12-month FFO per share, quite attractive given the metrics discussed earlier.

Due to pent-up demand from shoppers hoping to venture back out once the pandemic ends, I think this REIT should be in your portfolio.

3. Trupanion ($1.9 billion)

Trupanion is a low-cost, data-driven pet insurance provider that operates in the United States, Canada, and Puerto Rico. The company generates the bulk of its revenue from its subscription business, which collects recurring insurance fees from policyholders on a monthly basis.

A big problem facing cat and dog owners is how to budget for random and unexpected veterinary visits. Trupanion solves this issue by providing a valuable, high-quality member experience that utilizes pet health data to price policies unique to each pet.

The numbers back up just how successful this service has been. In Q1, total pets enrolled rose 25% over the prior-year period. Revenue has grown at a compound annual rate of 27% since 2015, while operating losses have shrunk significantly during the same time.

Many insurers operate with a combined ratio of 95% or above, indicating an extremely tight operation with only a 5% or less underwriting profit margin. Trupanion, on the other hand, seeks to maximize its adjusted operating income. At the end of Q1, the company's adjusted operating margin stood at 13%. Trupanion's goal is to reach 15% margin at scale, as fixed technology and administrative expenses are leveraged over growing revenue.

According to Trupanion's investor presentation this May, only about 1% of pets in the United States have health insurance, showcasing the company's massive opportunity. The COVID-19 pandemic and resulting shelter-at-home orders have also been a tailwind for the growth of the overall pet population. Americans spent $96 billion on their pets in 2019, and this number will continue rising in years to come.

The stock is up 41% this year alone through Tuesday's close, and currently trades at a premium to traditional health insurance providers, with a price-to-sales ratio of 4.5. Investors with a long-term view can appreciate Trupanion's significant customer value proposition, proven business model, and market opportunity, and will consider purchasing shares.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Neil Patel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Apple, Lululemon Athletica, Netflix, Tesla, and Trupanion and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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