Our recent Top Buy pick was Polaris (PII), a top maker of small vehicles such as ATVs, "side-by-sides", snowmobiles, golf-cart like people movers, European smart-car like quadricycles, and, increasingly, motorcycles.

You might be thinking the same thing as I did when I first looked at the company: can this really be a sustainable, great business like we are looking for from the Magic Formula screens?

After all, vehicles don't have any built-in economic moat advantages. There are no switching costs, no regulatory protections, no network effect... Nothing that would preclude customers from dropping a brand and moving to a competitor. In theory, that should limit the economic potential for any player in this market.

But, in fact, like Apple (AAPL) in consumer electronics or Starbucks (SBUX) in coffee shops, Polaris has managed to generate outsized returns on capital and returns to shareholders in a competitive market, through a company culture of innovation, efficient manufacturing, and superior management. I believe the company can continue this track record, and with the stock down over 30%, now is one of the best times to get in since the recession days of 2009.

Here are 3 reasons we like the stock, as well as a discussion of the risks involved.

Outstanding Track Record and Management

Have a look at Polaris' post-tax returns on capital over the past decade:

Pretty good, right?! Consistently at or over 30%, which is simply outstanding. And these are no "cruising" returns on capital either. Over that period, Polaris has grown revenues at at 10% annual clip while improving operating margins from about 11% in 2005 to almost 16% today. Share count is down 23% in that time, and the dividend has been hiked every year at an average annual growth rate of 12.6%. All together, earnings per share grew 19.1% annually in this period, and the stock increased 6-fold in price.

That is an outstanding track record, and there are no significant signs of weakness in recent results. Polaris has simply been a superbly run company.

The best results in those 10 years have come since current CEO Scott Wine took over late in 2008. Under Wine, Polaris has expanded into small vehicles with the purchases of GEM and Aixam, bought and resurrected the historic Indian motorcycle brand, and executed "lean" manufacturing beautifully, raising Polaris' gross margins from 22% in 2007 to 29% today. Under Wine alone, the company's revenue growth rate has been 21% and operating earnings 29.2%... annually!

Need further proof? Polaris' market share in ATVs and European small vehicles is #1, and it is #2 in snowmobiles and domestic motorcycles. The company's scale far exceeds competitors like Arctic Cat (ACAT) or BRP, giving it greater fixed cost leverage.

With Wine at the helm and the numbers proving Polaris' culture of innovation and outstanding operations, we can be comfortable we are buying an excellent company with superior management.

Indian (Motorcycles) On The Warpath

The second reason I like Polaris is its growth potential, and one of the big legs of that growth potential is the 2013 re-launch of Indian motorcycles, which Polaris acquired in 2011.

In American motorcycles, Indian is probably the only brand that even holds a candle to Harley-Davidson (HOG) as far as heritage. Classic Indian motorcycles are highly collectible and an affinity for the brand still exists today. Indian was America's first motorcycle company and was the market leader up through World War II. But the original company went defunct in the early 1950's and the brand was passed around a variety of weak parent companies up until Polaris snatched it.

And what a job Polaris has done. Using its product development, marketing, and distribution strength, Polaris has re-invigorated the brand. In 2014 (the first full year of availability), Polaris increased motorcycle sales by 59%, to $349 million. So far in 2015 (9 months), motorcycle sales have already reached $460 million and last quarter grew by an astounding 88% year-over-year. Essentially all of this growth has come from Indian brand sales... Polaris' legacy Victory cycle marque has actually declined.

When you consider that Indian's U.S. market share is still small at under 10%, I see plenty of growth potential here. And that is not even considering overseas potential, which exists for essentially all of Polaris' products (over 85% of sales are in North America). There is good revenue growth potential going forward.

Stock Is Cheap Vs. The Market... And Its Own History

Polaris' stock is trading at its lowest valuation - by far - since the "great depression" of 2008-09. Its current earnings yield is right at the 10% mark, compared to a 5-year average of 7.1%. That is a huge disparity and far out of whack with the stock's normal valuation. To put this in context, even if the stock just got back to that 5-year average valuation, it would trade over $160, more than 40% of upside!

The valuation is even more head-scratching when you consider that Polaris is far from a stagnant, no-growth operation. Estimates for this year peg a 11% rise in earnings per share (EPS). Early 2016 estimates are targeting EPS growth over 12%!

Simply put, the stock seems to be oversold and it is likely only a matter of time before it returns closer to its historical valuation multiples.

Risks

The beat-down on Polaris stock after Q3 earnings seems unjustified, driven mainly by a narrowing (not reduction) of guidance for 2015. This doesn't concern me that much. But there are some risks to be aware of.

First of all, as discussed earlier, small vehicle sales have no built-in moat advantages, and Polaris faces plenty of competition from well-heeled competitors including Yamaha, Honda (HMC), Arctic Cat, Deere (DE), Harley, and numerous others. It will take great management and execution to maintain its historical results. Should Scott Wine leave or there be turmoil in the boardroom, we would need to re-think the thesis here.

Secondly, Polaris sells "big ticket" items that can easily be deferred or canceled should economic times get tough. In a recession, Polaris is likely to get hit much harder than the average stock (although I don't see existential risk in such a scenario).

Finally, like anyone in this industry, Polaris is at risk to safety mishaps or recalls, which would hurt the company both financially and in the reputation department - not to mention the stock.

Conclusion

I see the risk/reward scenario here as quite good, and am happy to add PII to our Top Buys portfolio. It was a bit difficult to decide which risk portfolio to place it in, but overall the company is in a more stable position than many of our picks, so it will be placed into the "conservative" portfolio. The buy under target price is $115.