My 3 Favorite Small Cap Stocks for 2011

Off the radar — but only for a little while longer. That’s the investment thesis I look for when searching for stock ideas. Good companies, doing all the right things, getting set to pop up on more investors’ radars in the coming year.

These three companies look set to garner appreciation in 2011 for steps they are taking in 2010.

A holiday season play — and then some
Roughly a decade ago, Leapfrog (NYSE: LF) was the hottest name in the children’s toy space, thanks to a line of products called LeapPad, a tabular reading software platform that allowed children to read along syllable by syllable. The product was an instant smash, quickly selling millions of units. Word of mouth among moms proved at least as important as advertising. But the company was never able to follow up on that success: from 2003 to 2009, sales fell by more than -40%, and shares, which were once richly-valued, lost more than -95% of their value.

Yet as any parent that has recently browsed the toy aisles will tell you, Leapfrog is quickly becoming relevant again. In recent quarters, LeapFrog’s newest products are again gaining traction with parents and kids. Sales, which fell below $400 million in 2009, should exceed $450 million this year and top $500 million next year.

The seeds of a turnaround appeared in 2008 when the company introduced Tag, a pen-based computer system that can upload and download information. That summer, management also rolled out three new product lines, including an upgraded version of the original LeapPad. Those products are finally finding appeal with consumers.

That sales momentum should be in evidence this holiday season as Leapfrog’s products have been gaining all kinds of buzz among industry watchers. Most importantly, this shouldn’t be a one-time fad. As analysts at Imperial Capital recently noted, “The Leapster Explorer has been an early success thus far, generating the highest presale orders of any LeapFrog product in its history. Since its launch, it has been featured on many top holiday gift lists and has created significant buzz amongst retailers and consumers. We believe this bodes well for the holiday season and the long-term brand positioning and growth of LeapFrog.” Shares have rebounded from $4 to $6 as word of the rejuvenated Leapfrog has spread, but shares could hit $8 or even $10 if the holiday season is as strong as some suspect it will be for this erstwhile highflyer.

eResearch (Nasdaq: ERES)
This company would like to put 2010 behind it. It pulled off a savvy acquisition that is boosting sales and profits, yet its stock has drifted lower as investors have seemingly lost interest. In coming quarters, though, investors in eResearch are likely to re-visit this impressive growth story, pushing back the stock up to and beyond its 52-week high of $9.

I first profiled this clinical testing data provider back in May, soon after it pulled off a big acquisition. [See my article here]

Shares have fallen -20% since then. Though it’s wise to cut your losses on stock ideas that don’t pan out, an investment in eResearch in 2010 simply looks like bad timing, not a bad stock idea.

So what went wrong? The company announced in November that it filed a shelf offering to raise an additional $150 million. Management has subsequently told investors that it has no interest in raising fresh capital after its shares lost -25% of their value in the last month. In addition, the company has been operating without a permanent CEO, though that post is likely to be filled in the next few months.

If and when those issues move off the table, investors will again squarely focus on what is a solid growth story. The above-noted acquisition is set to boost revenue nearly +50% this year and another +30% in 2011. More importantly, EPS is rising at a +50% clip. Beyond 2011, eResearch will likely need to pull off another deal — perhaps in the field of “Automated Algorithms,” which has become a new testing approach among Contract Research Organizations (CROs) — as it further extends its platform to become a one-stop shop for Big Pharma customers. While CRO rivals such as Covance (NYSE: CVD) and Charles River Labs (NYSE: CRL) trade for more than eight times projected 2011 EBITDA, eResearch fetches just 4.5 times 2011 EBITDA.

KVH Industries (Nasdaq: KVHI)
Once a ship is out at sea, a phone call home — or simply watching satellite TV — can be quite costly. After many years selling navigation equipment to commercial and military ships, KVH is using its expertise to also deliver a full suite of reasonably priced communications and entertainment services for those out at sea. The company’s TracPhone is being used on an increasing number of ships, generating high-margin recurring revenue streams. And that steady ramp up in customers looks set to coincide with an impressive rebound in its core navigation business.

KVH doesn’t run a network of satellites. Instead, its expertise lies in its antenna technology that can help pull in weak signals and deliver voice and data at prices lower than other satellite-intensive firms. The company’s high-bandwidth, low-cost approach could be facing a potentially large target market: estimates that there are more than 50,000 ships at sea in any given month. The International Maritime Organization’s estimate is closer to 100,000.

KVH’s 2010 results can be summarized quite easily: strong defense-related business for its FOG (fiber optic gyroscope) navigation equipment and more modest results for that nascent TracPhone business. Total sales are likely to finish the year about +25% above 2009 levels. Looking into next year, the stars appear aligned for both cylinders to be firing, leading to a further +20% to +30% gain in sales.

The TracPhone business should finally build a head of steam now that KVH has a truly global footprint in place. The Coast Guard just signed up for a 10-year, $42 million contract, and KVH is expected to secure other key wins over the next few quarters.

Yet this remains as a “show-me” stock, as shares have largely moved sideways in the past year. As both cylinders start to fire, shares could finally move up toward the $20 mark, reflecting the long-term view of strong growth and rising recurring revenue streams.

Action to Take –> These three stocks remain below the radar, even as they are steadily building out their product lines to capture more customers and bag higher profits. Next year could shape up to be a breakout year for these names.