Underappreciated Rule-Breaking Small Caps

0:04Today on Motley Fool Money, we're diving into three small caps that are off most investors' radars, but not ours.

0:20I'm Emily Flippen, and today I'm joined by analysts Jason Hall and Toby Bordelon to discuss each of our picks for rule-breaking small caps that we expect our listeners may have never heard of before. We have a rapidly expanding tea house with unit economics that will make your mouth water. A nice industrial player that I expect Toby thinks is undervalued. But to start, let's talk about a couple of small caps in an industry that may have been written off entirely. And Jason, I actually think saying that this sector, which is the energy sector, saying that it's been written off is actually really probably an understatement.

0:54It's been one of the worst performing sectors this year, with green energy in particular, losing a lot of policy tailwinds as initiatives have been increasingly rolled back. And yet your small cap pick really flies in the face of that narrative. So why is this sector and renewable energy in general worth a second look right now? Well, I think it's so compelling. And in the rule breakers mindset, I'm going to immediately break the rules and talk about two stocks that I think are compelling that are part of two different parts of the story here. Renewable energy stocks, like you said, they've really it's not just been this year.

1:26They really struggled. Since interest rates started to be ratcheted higher back in 2022, we saw central banks around the world take aggressive steps to fight out-of-control inflation. The reality, and if we look at solar, really there's two different segments. There's residential, which is, call it a third of the market, and then the other two-thirds is utility scale solar. It's expensive. And the reality is that it's almost always funded with debt. So interest rates going up, that really hit residential solar extremely hard. And of the two stocks that I'm going to talk about, Enphase, which I'm sure a lot of people that listen to the show are familiar with, it makes the electronic components of the solar system.

2:06It sent their microinverter unit sales down 70 % from the peak to the bottom. And just when we saw what looked like a bottom, that was last fall, unit sales rebounded over the summer from those lows. we saw the U.S. federal incentives for renewables get gutted as part of the big, beautiful bill. Now, that's clattered up. What had been a clearing sky, we look on the utility scale, we can look at Fluence Energy. That's the large-scale battery-making love child of Siemens and AES, which are two companies that are very much involved in the energy industry. Its business and stock price has really been whipsawed more over the past year on a combination of the growth story unraveling, while competitors like Tesla saw its battery business kind of hold up pretty well.

2:53And for investors who are unfamiliar, Enphase's ticker is ENPH, Influence Energy's ticker is FLNC. It's absolutely crazy that we're sitting here talking about both of these businesses as small caps. I mean, Toby, you work with me on the Stock Advisor team, and we have Enphase Energy actually as a recommendation on the rule breaker side of the Stock Advisor scorecard. When we recommended it, it was very far from being considered a small cap, and now it's sitting at around a$5 billion market capitalization. When you think about Jason's pick here, what questions come to mind? Yeah, well, it's really not a surprise, I think, as Jason noted.

3:30As I said, it's been hit. Investors have become skeptical on the industry, right? And they're moving on to other places with investment dollars. not at all a surprise given what we've seen in the headwinds facing this company right now. Yeah, I think for public investors, yeah, that are looking at the stocks, that's the case. Because especially if you're not intimately familiar with these industries, understanding the difference between the cycles, and we're at a brutally down part of the cycle right now versus the secular tailwinds, it does certainly feel like it's been left for dead right now.

4:07But when you start pulling apart the cyclical manufacturer part of the business and looking at the secular tailwinds, there's a little bit more to like right now than I think you might think. And for a company like Enphase, there's a few things that I think are really appealing. I think the economics might be better than people realize. Now, as a starting point, Enphase has actually continued to take market share during the downturn. It and SolarEdge essentially have a duopoly in the U.S. They have about 90 % of the residential share, and pretty large share in Europe and other parts of EMEA. And they both also have really good margin in cash profiles.

4:46Enphase has also done a really smart thing leveraging contract manufacturing. And as a result, it's actually remained cash flow positive every quarter through this down cycle of the business. We can bring Fluence into the conversation here. really had a brutal first half of the year after a great 2024. It seems like management just really missed the mark on understanding what the business flow is going to look like. But here, as we've gotten into the second half of the year, business has stabilized and management has reiterated that outlook. Now, its catalysts include continued focus on deploying utility-scale wind and solar and also grid resilience.

5:22You think about those are things when we come to energy storage. And after showing that it had the business model before the first half of this year, it looks like it's set up to really start generating positive cash flows as we move forward. Now, that being said, part of me just wonders, does it even really matter if there's no federal incentives or what happens to that cash flow? And Toby, I know the stock pick you have coming up for us here in just a couple of minutes is kind of the antithesis of this sort of pick. So when you think about playing devil's advocate to Jason's idea here, what stands out to you as key risk?

5:57Because for me, obviously, federal incentives are the obvious play. Yeah, I think that is the obvious one. You can't ignore the political risk with this company. This administration is simply not as excited about renewables as past administrations have been. That's a problem, at least over the short term for the company. Now, look, you might say, who cares? For instance, AI is going to boost our need for energy. So, there won't really be a choice here. We've got to have energy from wherever we can get it. I'm not convinced that's really the case, though. I am worried that we may be in a bit of an AI bubble.

6:31And if that collapses, demand overall could go down. I think on both of those things, you're right to some degree, Toby. There's absolutely no doubt the loss of those tax incentives is going to have an impact. For the rest of 2025, it's actually a catalyst. Homeowners are moving really quickly to get that residential system installed before the credits expire. On the utility side, there's a little bit of a bigger time window for utilities to act. But beyond that, I think we're ignoring a really important thing on the math here. Utility costs are up more than 40 % since 2019 in most U.S. markets.

7:09Now, that's far more than solar system costs have gone up. So, between higher utility costs, helping offset the need of those tax credits, and then interest rates now starting to creep down. That was the news cycle last week, right? It was all about what was the Fed going to do. I think residential solar, in particular Enphase, is probably in better long-term shape because of the secular trends than we think. And we haven't even talked about the international opportunity, which I don't really want to get into very much. Yeah, that's true. I just wonder, you know, speaking about the large scale, the industrial side of this, you know, the utility side of this, a lot of demand right now is coming from from AI.

7:48If that bubble does burst, does that mean we're in an energy slump? What if we find ourselves with a bunch of half built suddenly unneeded infrastructure here, Jason, because the demand just craters? Right. What does that do to influence a stock price? I don't think it sends it up, does it? No, definitely not a go to the moon scenario if that happens. But I think if we look at the long tail opportunity, yeah, AI is certainly a part of the thesis. It has to be because that's the biggest catalyst driving total energy consumption in the U.S. by far. But large scale energy storage is about more than just AI.

8:21This is about grid resilience. Think about how much we've talked about. You live in the West, Toby. Grid resilience is a significant issue. Think about what Texas dealt with with winter storms a few years ago. We're going to continue to see a transition away from things like coal as a baseload. That means utilities will need more storage to offset wind and solar intermittency. So I think meeting the energy demands of the world is going to remain in all of the above or most of the above in terms of the energy sources. And storage is going to be a really important part of that formula. Well, I love the debate between you two.

8:56And I go back to Dave Meyer, actually, who brought Fluence Energy to me a number of, I want to say a couple of years ago, to the Blastoff team. and before AI was really a big part of the thesis and said this was just an obvious opportunity. And while the thesis, I think, has very much changed over the course of the past couple of years, there is part of me that thinks, while there's so much volatility in the space, and clearly I think investors who are interested in getting into renewable energy in this entire sector, Fluence Energy, Enphase, whatever it may be, they need to have a stomach to stand the volatility that comes with a lot of the political changes that are likely to continue over the course of the next couple of years.

9:32If you believe in the obvious transition and the need for renewable energy and renewable energy storage, then it sounds like, Jason, there's lots of different ways to play this trend, influence energy and phase R2 to consider adding to your watch list. I think that's exactly right. And again, there is still tremendous uncertainty and risk, but this is also where position sizing as investors comes in. It's a way that we can kind of offset some of that risk, still having exposure, being able to continue to follow the story and see how it pans out and maybe take the most rule breaker, important thing of all to do.

10:02And that's look to add to our winners over time. Beautifully said. Up next, we're passing the torch to Toby to dig into an automotive business that has more than doubled since the start of 2024. Stick with us. Whether you're trying to analyze market or business trends or dig through hundreds of pages of quarterly reports, the sheer volume of data can feel overwhelming. Lately, I've been using Claude's deep research feature as my ultimate thinking partner. I hooked it up to my Google Workspace tools and it was able to run a reliable, comprehensive analysis across dozens of different financial sources in minutes, helping me spot long-term connections that on my own, it may have taken me hours or even days to see.

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11:24And I want to read to our listeners exactly what I read when I checked in on our show notes. Is everybody ready? You wrote, buy Finia if you don't want your portfolio to tank when Tesla goes bankrupt. Big words. Now, I have to imagine there's at least some tongue-in-cheekness there. But I have to know that you are a bit of a bear on Tesla. So why is Finia, whose ticker, I believe, is P-H-I-N, if I'm not mistaken, which is almost the antithesis of Tesla, why is Finia the better buy today? Yeah. And let's be clear, a lot of that was just me saying, let's stare up in trouble when Emily gets up in the morning.

12:02But in seriousness, this smaller, lesser-known company, I think is a great way to hedge your portfolio, not just against Tesla, but the whole EV transition, which let's face it, is not happening as fast as some of the techno bulls might like it to right now. Look, Finia is an auto parts manufacturer with roots that go back over a century. This is an old company. If you're a car person, you know the brands here. Delphi, Delco, Remy, Hartridge. The business and the brands have been around forever, right? But the company itself is relatively new. This is a spin out of a much larger auto supplier, BorgWarner.

12:41About two years ago, July 2023, they spun out Finia. The idea here was BorgWarner wanted to focus on the future, electrification of the industry, EVs and hybrids. They didn't phrase it like this, of course, but Finia was essentially created to take all the leftover nonsense that they didn't want. The legacy ICE businesses that was catering to the dying parts of the industry. Well, guys, as it turns out, that part of the industry has refused to die. In fact, since the spinoff, Finia has massively outperformed its former parent, BorgWarner. About a 68 % total return in the past two plus years or so versus less than 8 % for BorgWarner.

13:23Finia has also outperformed the S &P 500 by a little bit. Pretty good for unloved leftovers, I would say. Toby, history is littered with spinoffs that outperformed their former parents. I think a big part of that is that those businesses, they don't have to compete with their siblings anymore for their parents' attention, really, resources. Now, my question for you is that in the short term, two years, we've seen Finia be the better investment, but will history continue to be the case here? Or will that future of electrification that Finia can be the hedge against, will that render the company obsolete and a losing investment?

13:55Yeah, it's a legitimate concern, Jason, I think. I think it's going to take decades, though, before EVs overtake ICEs. The future never comes as fast as we think it will. but they're not ignoring the inevitable future. Finia is not at least. They're investing in things like hydrogen technologies, remanufacturing, software and calibration tools for increasing the efficiency of ICE engines, that sort of thing. Look, if you want to believe that EVs are going to take over the world within a decade, you go ahead and do you. But if you subscribe to the reality that change tends to be more evolutionary across an industry, then there are many customers who are just fine with enhancing and improving the existing systems they use rather than totally junking in for something new.

14:38And if you think that's the case, Finneas is a company that might be for you. I love that. If you subscribe to reality, well, here's the reality I subscribe to, Toby. I take issue with the comparison to Tesla. And, you know, albeit a whole one for me to really defend Tesla here because it's a little silly for me to do so, but I'll try, which is to say, I don't really understand what makes Finneas cash any more durable than Tesla's Because from what I can tell, Finia's profitability is pretty low, their debt's really high, and most of that cash has to be reinvested into their business. And in my opinion, despite the fact that you're right, I think the transition to electric vehicles will be slow.

15:16Finia is just another example about why auto companies are kind of generally bad investments. I mean, Tesla's valuation, we can debate that all day, all night. But Tesla has a stalwart balance sheet. It has profit margins that are more than double Finneas, and its growth rates are even higher. And yes, I'm aware that both their growth rates are negative. I just don't understand how either of these companies, how you come out looking and say, yeah, I like Finneas more here. I think for me, Finneas is not necessarily a pick against Tesla or a pick against any specific company, right? I like it as a nice hedge against an EV transition that may be slower than expected.

15:53That appears to be the case right now. I'm not saying EVs are not going anywhere. I own two electric vehicles myself. I love them, right? But we have to, I think, face reality that the Super Bowl cases have not materialized and probably will not. I like using a supplier like Finia if you're considering hedging your bets because it actually doesn't require you to pick a winner, right? You don't have to look at all the consumer-facing companies out there in the automotive industry. This is the one that's going to win. Who was the number two EV maker to Tesla in a decade? I don't know, right? Is it GM?

16:25Is it Toyota? Is Ford going to be the company that successfully straddles that line between the EV transition and the legacy world of ICEs? I don't know. The good news for financial shareholders is you don't actually have to make that pick. You can say, look, I'm going to play in the parts space. I'm going to buy a company that sells our parts to anyone and will do well in a transition and maybe a slower transition and will continue to sell parts to the legacy legacy automakers for systems that are still very much needed in the marketplace. Do sales of new cars decline and consumers hold onto their older ones a little bit longer in the face of rising tariff costs?

17:02For instance, if that happens, great. Finia's got a thriving aftermarkets park business take advantage of that trend as well. So I think there are a lot of things to like, and there are a lot of reasons you might look at Finia and say, this is the company I want, even if I am a believer in the EV transition ultimately happening. That's a really good point. And there's a false dichotomy there that it's Finia in this case versus Tesla. And both actually are recommendations on the Stock Advisor Scorecard. Finia threw that spinoff from Bork-Warner, as you mentioned. And Tesla actually is one of the original kind of rule breaker stock picks from Motley Fool co-founder David Gardner, who actually have a little bit of a teaser here for our listeners today.

17:43David Gardner, co-founder of The Motley Fool and chief rule breaker, actually just released his newest book, Rule Breaker Investing, How to Pick the Best Stocks for the Future and Build Lasting Wealth. But there is more alongside this. David will be serving in a strategic advisory capacity for The Motley Fool's new Supernova service, one of the portfolios of which I will be the co-captain of. It's a service that closed in 2021, with portfolios averaging a 21.8 % annual will return across nine years. And Supernova will be reopening, actually, for the next few days. You can go to supernovaisback.fool.com for all the latest details and to become a VIP for the event.

18:18Coming up next, we're discussing a still small but rapidly expanding high-end Chinese tea chain. We'll see you in a minute. Support for the show comes from Fundrise. For the past 70 years, there's been a room in finance most people couldn't enter. A room where you could have invested in some of the biggest names in tech, companies like Airbnb and Uber before their multi-billion dollar IPOs. I'm talking about venture capital. Fundrise recently took a sledgehammer to those closed doors by launching a venture capital product that's available to anyone. Their mission is to give everyone the chance to invest in the best tech and AI companies before they go public.

18:55You can visit fundrise.com slash fool to check out Fundrise's venture portfolio and get in early today. All investments involve risk, including the potential loss of principal. Past performance is not indicative of future results. This is a paid advertisement. For our last stock here, I want to try to pitch you both on a business that you've likely never heard of before, but I expect you're both going to be rightfully skeptical of, and that's Chaji Holdings. The ticker is CHA. Now, this is a growing chain of high-end tea houses out of China. And yes, similar to Luckin Coffee a la 2020. They're expanding very aggressively via a franchised model.

19:33And I know for a lot of investors, that throws off a lot of red flags. But I hope you'll hear me out in this little elevator pitch, and then you can cross-examine me. This is a founder-led company. It was started in 2017 by a 23-year-old, Zhang Junjie, who still owns more than 35 % of the company, actually. It has a market cap of around$3 billion, and it just went public earlier this year, so it is new to the public markets. The stock is down, admittedly, nearly 50 % since the IPO. But the growth this company has put forth is wild. Store count up more than 80 % last year, and a loyalty program that has over 200 million active members.

20:08They don't sell bubble tea. They sell high-end tea lattes, which sell for higher price points and come with a bit of the Starbucks-esque brand attached to them. Their GMV and store economics are absolutely incredible. The profitability is actually pretty high. And over the past 12 months, the business has produced nearly$300 million worth of profits on around$2 billion in sales. The stock trades at less than 12 times price to earnings. Come on, Emily, what's the catch here? A stock growing at hyper level rates based in China, trading for 12 times earnings. Let's be honest here. In investing, if it sounds too good to be true, it almost always is.

20:48There's no catch, Jason. It's the perfect company. Everything's going to go right for it. No, of course, there's always a catch. If I had to throw something out there, obviously cannibalization. I mean, this is a franchise model growth. It's leading to a massive slowdown in same-store sales growth. And that similar slowdown in same-store sales growth is, of course, leading to a similar slowdown in profits. So the market is projecting a massive crunch here on the bottom line as the business kind of like right sizes its store count. For context, they have more than 6 ,000 locations across the world.

21:18They're mostly in mainland China. That's a fraction of the locations of like a luck in coffee for comparison. But they have massively expanded very, very rapidly. And the store economics that look so good today, I imagine a couple of years from now are going to look a lot less impressive. Hey, speaking of coffee, Emily, isn't coffee better than tea? I mean, haven't we heard for so long how China, for instance, right, the biggest tea market on earth, is discovering a love for coffee. And it's not just Starbucks, that other company you mentioned, Luckin, they're surging right now. Where does tea fit in in this world in terms of a long-term growth play?

21:56Well, it's a little ironic. I'm drinking a cup of coffee as we record here today. So obviously I'm a coffee drinker, but you know, not everybody loves coffee and I like tea just as much as I like coffee. And the good thing about tea is you don't have to worry about the growing conditions in certain regions to make your coffee beans. And you don't have to worry about the tariffs, at least that we're experiencing right now. I will say that this is really, it's honestly more like lattes. You can kind of imagine it. It's more of a premium brand. So I think the comparison to Luckin Coffee is really misguided.

22:28You can almost compare more to a Starbucks because you can imagine that's more of their competition as opposed to a luck in coffee. Caffeine, cream, and sugar. That's the secret to success here. Now, Toby mentioned, you mentioned it too, this is a new public company that adds another layer of risk. How can a company perform in the public spotlight? So definitely kind of ramping up my normal IPO skepticism. And then you double it when you're talking about China. Now, as unfair as that might be, But I'm less concerned about Luckin 2.0, of course, the big scandal there with fraud, but more thinking about China's demographics.

23:09This is where their base is, and China's getting very, very old very, very quickly. Is that potentially something that could unravel the growth story over the longer term? That's a really good point, and you're concerned about it being a Chinese company, listen to U.S. markets, and the concerns about it being newly public, that's all fair. Big red flags there, of course. You can wait this one out. Actually, a lot of their expansion has been in East Asia, Malaysia in particular. So their international expansion is actually one of the bright spots for this company. They only have one location here in the United States.

23:37I believe it's in Los Angeles. So if you're out there, maybe go check it out. I've heard mixed reviews so far about whether or not people like the product. But East Asia in particular is a big growth story for them. So it's not just about expanding within China. But I am going to put you both on the spot here as we wrap up today's show for a little lightning round. If you had to pick a company, let's say not the one that we brought. obviously, out of the three that we talked about today. Which one are you talking with, or which one are you picking? Toby, I'll start with you. Despite my skepticism here that I may have been evidencing when Jason was talking, I think I'm going to go with energy right now.