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Smaller-cap growth stocks have been laggards, but their time is coming, says James Oberweis, president of Oberweis Securities, who specializes in the micro-, small-, and midcap investing arenas.
Oberweis looks for companies with a minimum of 30% growth in revenues and earnings. And he actually has a few of those on his list -- for example, Vital Images, ESS Technology, and InVision Technologies (which specializes in bomb-detection equipment). Companies with growth on the scale he likes tend to be in tech and health care, he says.
In the difficult year of 2001, Oberweis reports, his small-cap growth portfolio grew 0.5% at a time when the Russell 2000 growth index fell 9%. So far this year he is in step with that Russell index.
Oberweis made these points in the course of a chat presented Aug. 8 by BusinessWeek Online on America Online. He responded to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from this chat follow. A full transcript is available on AOL at keyword: BW Talk.
Q: Jim, this is the third day of double-digit gains on the Dow. Is the third time the charm? Is the market finally turning the corner?
A: For much of the past two years, equity valuations have continued to decline, and, finally over the past few days, it appears that we have a bit of a different pattern. I expect that the bottom has already been reached, but that doesn't mean that the market won't go down again. But I think we're probably pretty close to the bottom range.
Q: Can you update us on how small stocks are faring so far this year? Have they come down as hard as large caps? Are there still bargains in the small-cap area?
A: In much of the past two years, small caps have lagged large caps by a wide margin. So far this year, the Russell 2000 growth index, which measures the performance of small-cap growth stocks, is among the worst indexes of year-to-date performance, with a really ugly 34% decline.
On the other hand, the situation is a bit different on the value side, where value stocks are only down about 13%, far ahead of the S&P 500. So it has been two small-cap worlds, growth lagging and value leading, but we think that because of the duration of the value rally, growth is a place to be investing now.
Q: What companies with growing revenues and earnings do you like as buys today? Would they be value stocks?
A: The answer is no. By definition, value stocks refer to those companies with low price-to-book ratios, while the companies that we like tend to be companies with extraordinarily high growth rates. In fact, the minimum growth rate that we look for in companies is 30%, both in revenues and earnings, and indeed those companies typically require a premium valuation multiple relative to value stocks.
Q: What are some of the specific companies you like now?
A: Let's start with three of our favorites. We like a small company called Vital Images (VTAL
), which develops software for 3D visualization of CRT procedures and virtual colonoscopies. Second, we like a company called ESS Technology (ESST
), which makes chips for DVD players. As you may know, DVD is the single fastest-growing area in the semiconductor industry, and ESST is a leader in DVD chips. We also like and own a competitor of theirs called Zoran (ZRAN
). Also, I'm intrigued by InVision Technologies (INVN
), which has a 95% market share of all bomb-detection equipment, and, unfortunately, we expect explosion-detection equipment to be a growth industry for the next 5 to 10 years.
Q: In which sectors today are you finding any of the 30% growth in revenues/earnings? Sounds like you are high on some in tech.
A: In the 15 years that our team has been searching for small-cap growth stocks, this year has been the most difficult year to find a high-growth company. That said, it's getting easier. This quarter is significantly easier than last quarter, and in general, we're starting to find good ideas again, and frankly they are significantly cheaper than we've seen at any time in the past five years. Of course, we always tend to be a little weighted in tech and health care, because that's where we find change, and growth companies tend to focus on areas of change.
Q: Jim, among the micro-, small-, and midcap areas, does any one look best now? And are there any significant variations in recent performance?
A: There are absolutely variations in recent performance. To be qualitative, it has been an exceptionally difficult time for midcap growth stocks. For example, the Russell 2000 midcap growth index is down 29% this year, and lost over 20% last year, whereas the Russell 2000 growth index is down only 15% this year, and 9% last year.
While I don't believe that the Russell company publishes a microcap index, I can see from our own fund's performance that the best place to have been in the last couple of years is in the microcap stocks, which have done quite well -- particularly in 2001. Of course, value in any category outperformed growth in the past three years.
Q: Have you done anything differently in your funds during the severe weakness in the last few months? Have you been buying or turning over a lot of holdings, or just waiting it out?
A: We tend to remain fully invested throughout the entire market cycle. We don't think it's possible to time short-term market fluctuations, and, accordingly, take advantage of the natural positive upward bias -- though it doesn't seem very upward these days -- of the market, and stay fully invested at all times. Of course, it would be great to sell when the market's high and buy when the market's low, but I'm not smart enough to know when to do that.
Frankly, I think I'm not alone in that -- I've never seen one single documented track record over 10-plus years of anybody who has made money timing the market. When you think of the legendary investors, the Peter Lynches and Warren Buffetts of the world, they all made money by buying companies and staying invested for long periods of time.
Q: What do you think about Liberty Media (L
)?
A: ...our focus is on profitable small growth companies, and we find it hard to make a lot of money in the communications business right now -- although I have to tell you, I'm becoming intrigued with the absurdly low valuation of some communications companies, specifically those in the cable industry that have been so plagued by the fate of Adelphia.
I'm talking about companies like Charter Communications (CHTR
) that are being valued with a discounted assumption of a high probability of bankruptcy or some other financial restructuring. Although we admit the possibility, many of these unloved companies may prove to be good investments in time.
Q: Any small-cap banks left out there? Or is that an oxymoron?
A: You know, one company that looks interesting is NetBank (NTBK
). The company recently reported its second-quarter financials, and though confusing, they appeared to be quite reasonable. Of course, the valuation, because of the tech component, is on the low side, and it might be worthy of further exploration.
Q: How badly were you hurt by the bursting of the tech bubble, Jim?
A: We were hurt, no question about it. But actually, considerably less than some of our peers. We're a small-cap growth manager, which means you would expect the greatest degree of correction for us relative to any other asset class.
In 2001, however, we actually were up 0.5%, while the Russell 2000 growth index fell 9%. This year, we're right in line with the returns of the Russell 2000 growth index. We've probably benefited from the requirement of our investment process to buy only profitable companies. While tech as a whole declined rapidly, it was most pronounced in companies without earnings, which we didn't own.
Q: What about semiconductor stocks? Any picks?
A: Very few at this point in time, but there are a few that look interesting. After a great quarter, Cabot Microelectronics (CCMP
) looks very good at about $42. This company makes a mixture of chemical ions in water that's used in the process called CMT for the manufacture of advanced semiconductors. Cabot has an 80% market share, and the dominant position in the slurry industry. Also, as I mentioned before, we like two companies that make chips for DVDs called ESS Technology and Zoran. We also think that companies with chips in the defense industry are likely to do quite well.
Q: Are there any niche players you like in the defense sector? (CRDN
) [Ceradyne] springs to mind.
A: Ceradyne actually looks quite interesting. In particular, my favorite right now is L-3 Communications (LLL
), which supplies sophisticated communications systems. And of course, InVision seems to have a lock on the explosion-detection market.
One other company that might be worthy of consideration is Meridian Medical Technology (MTEC
). While not directly a defense company, Meridian manufactures autoinjectors for the self-administration of injectable drugs. Of course, a company like that does very well when the government seeks to vaccinate large numbers of people in short periods of time. And, in fact, the government was a major client post-9/11.
Q: Any retailers catching your eye? Quite a few seem to be the rare exception of growing the top and bottom lines.
A: There's a few. Chico's FAS (CHS
) markets to baby boomer women and has done very well. In fact, Chico's is the largest position right now in our small-cap fund. I also recently took a position in Aeropostale (ARO
). The company is a retailer that focuses on young women and young men from 11 to 20. We also like a number of restaurant chains like Panera Bread (PNRA
), P.F. Chang's China Bistro (PFCB
), and Cheesecake Factory (CAKE
).
Q: If you had to buy just one stock and take it to the bank today, what would it be?
A: Of course, the Oberweis Emerging Growth Portfolio, but of course, I'm sure you're asking about individual equities. And it would be nonsensical to buy only one high-growth small-cap stock. I highly recommend a diversified portfolio of companies, and I'd be glad to share our 50 favorite ideas in our investor advisory letter called the Oberwise Report. We would be glad to send a sample issue to anybody who e-mails me at Moberweis@oberweis.net.
Q: What stocks have done best for you since the bursting of the bubble?
A: One microcap name that has done extraordinarily well is a company called J2 Global Communications (JCOM
) that produces a product that allows a computer user to receive a local telephone number and receive faxes on a computer, just like e-mail. The company grew at over 100% last year, and the stock is up from about $2 and change to $18.71.
In our midcap fund, we've done very well with for-profit secondary education companies like Career Education (CECO
). Also, online travel company Expedia (EXPE
) has done well for us, and in our small-cap fund, we have a very unusual winner -- a Polish vodka distribution company called Central European Distribution (CEDC
), which I think I mentioned the last time I was on this chat as a buy candidate.
Edited by Jack Dierdorff
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