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2001 BW 50

SPRING 2002

INVESTING FOR GROWTH

Small-Cap Stars
Small caps have been whupping the big guys for two years now--and they'll probably keep it up


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Investors who loaded up on big-cap stocks last year to bullet-proof their portfolios against the slowdown learned for a second straight year just how wrong they were. Many may again be wishing they had bet on smaller-company stocks instead. Indeed, while the Standard & Poor's 500-stock index dropped 16.8% during the 12 months ended Feb. 15, the S&P SmallCap 600 index, comprising U.S. stocks with a market value of $1.5 billion or less, lost just 1.9%. And the positive influences that helped mitigate the damage for small caps in 2001 aren't fading. For one, companies that dominate the small-fry universe often have simple business models and accounting, a selling point for investors who fear that any complex, global conglomerate could turn out to be the next Enron.

Moreover, if history is any guide, shares of small companies still have a lot of room to outperform larger companies. Small stocks tend to whip large ones after a recession. Twelve months after nine of the past 10 recessions ended, small stocks gained 7.5% more than big caps, says Steven DeSanctis, director of small-cap research at Prudential Securities. And that's just for starters. On average, once small caps begin outperforming large ones, they continue to do so for six years and by 13% a year on average, says Jamie Harmon, portfolio manager of three Fidelity funds that invest in small companies, including the Fidelity Small Cap Independence Fund. That means this cycle could run until 2004, he says.

But small stocks need to be approached with caution. Biotech and tech stocks are still languishing, while others were more directly hurt by the fallout from the terrorist attacks. So BusinessWeek and USA Today teamed up to help investors sort through the morass of small-cap companies, using the S&P SmallCap 600. Size isn't the only criterion for picking the 600 stocks in the index. The stocks must also be actively traded and have less than 60% of their shares owned by large entities, excluding mutual funds. S&P also requires companies to post net income on an operating basis, excluding merger costs, for four quarters. Stocks were ranked by their one- and three-year stock market returns as of Feb. 15 (table, page 150).

It turns out that investors in this market last year would have done well to stick to the basics, such as food and clothing. The No.1 company? Panera Bread (PNRA ), based in Richmond Heights, Mo., an up-and-comer in the "fast casual" dining market whose stock price more than doubled in the year ended Feb. 15. Panera owns and franchises about 370 restaurant-bakeries that operate mainly in the Midwest, South, and East under the Panera name.

Consumers salivating over Panera's line of roughly 15 breads baked at its stores drove revenue up 32.8%, to $201.1 million, in 2001, while net income raced up by 91.9%, to $13.2 million. Its profit in 2000, $6.9 million, came after two years of losses. With cushy sofas dotting its stores, Panera is creating a cachet for breads similar to what Starbucks created for coffee. And Panera has added coffee to its lineup so it can lure some of the midday nibblers. "Doing bread well gives you freedom to do breakfast and lunch," says Chief Executive Ronald Shaich.

Houston-based Landry's Restaurants (LNY ), whose stock returned 95.4% last year, was another successful food play. It owns and franchises nearly 200 locations across the U.S. and Canada and as far off as China. Revenue rose 43.3%, to $746.6 million, in 2001, as net jumped 83.8%, to $26.9 million.

While best known for its Joe's Crab Shack seafood restaurants, the company's windfall came from resuscitating the Rainforest Cafe chain. CEO Tilman Fertitta bought the ailing chain in 2000 for just $75 million after Wall Street had all but given up on the restaurant's recipe of luring tourists with its Amazon theme and then selling them overpriced and sometimes marginal food and trinkets. Fertitta slashed prices and got rid of half the items on the menu, including what he calls "weird pasta dishes." Offerings such as crab cakes have taken their place. Now, Rainforest's 25 U.S. locations, which have begun attracting repeat customers, should generate $30 million in cash after expenses this year, Fertitta says.

Just as Landry's turned around Rainforest by making its offerings more affordable, Memphis-based discount retailer Fred's (FRED ) found similar success with housewares and furniture. Last year, Fred's pored over its price list to make sure it met or beat Wal-Mart Stores' prices. By doing so, says CEO Michael Hayes, Fred's has diverted customers heading to the local Wal-Mart. Last year's economic slowdown prompted discount customers to spend less at each store visit, but to shop more frequently. This benefits Fred's, he says, because its smaller stores are easier for customers to get in and out of quickly. Fred's boosted net income by 32.2% to $19.6 million during its fiscal year ended Feb. 2; its revenue rose 16.6% to $910.8 million. This fiscal year, Fred's plans to add 60 stores to its 380-store chain. Wall Street clearly likes the expansion plans. The stock gained 153% in the 12 months ending Feb. 15.

Other small-cap companies did well on a more upscale tack. Chico's FAS (CHS ), which topped last year's list of SmallCap Stars, placed in the top 10 this year by sticking to casual clothes for well-to-do women. Chico's FAS has done well because its customers aren't fazed by a recession unless it's "deep and nasty," says Chief Financial Officer Charles Kleman. While same-store sales plunged 30% during the week of the terrorist attacks, they ended up 1% in September, 6.5% in October, and 18.7% in November. So even as the recession wounded department stores, Chico's revenue grew 45.8% to $378.1 million during the fiscal year ended Feb. 2, and net income, 48.6% to $42.2 million. Such success in difficult times is the result of "giving our customer what she wants--an outstanding product, in a friendly store environment, that makes her look and feel good," says CEO Marvin Gralnick, who along with his wife, Helene, co-founded Chico's FAS in 1983.

Some small-cap stocks have begun doing well in anticipation of their business improving along with the economy. Take Winnebago Industries (WGO ), based in Forest City, Iowa. RV sales are an early indicator of a rebounding economy, and in early January, Winnebago began ramping up production as orders climbed 70% from the year before and 50% from the end of its first fiscal quarter on Dec. 1. The introduction of two new gas-efficient vehicles last year and Americans' sudden fear of flying also might have helped orders. So while Winnebago's revenue fell 9.5%, to $681.8 million, and net income dropped 11.8%, to $42.7 million, in the fiscal year ended Aug. 25, its stock in the 12 months ended Feb. 15 has returned 127%.

In San Diego, meanwhile, CEO Michael Nicita of Advanced Marketing Services (MKT ) says the company is benefiting--and finally being noticed--for moves it made years ago. For example, the company, which handles book distribution for retailers, tailored its inventory management and distribution services to warehouse clubs. It also bought a 25% stake in a company with the Canadian distribution rights for the Harry Potter books. These initiatives, coupled with cost reductions, let Advanced Marketing boost net income by 11%, to $20.1 million, during the nine months ended Dec. 29, even while revenue rose just 1.2%, to $578.3 million. The stock has responded, returning 71.4% during the 12 months ended Feb. 15. For Advanced Marketing, as with many small caps, the Wall Street attention is welcome, if a bit overdue.


APRIL 2, 2002



By Matt Krantz, USA Today



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