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Smaller-cap stocks should continue doing well as the market and economy improve, says Robert J. Sullivan, portfolio manager of Satuit Capital Micro Cap Fund (SATMX
). They still have favorable valuations, he notes, and he expects domestically oriented small companies to outperform their larger bretheren. However, he urges investors to diversify and to keep their micro-cap stocks at 15% to 25% of a portfolio.
The fund he manages ended 2002 down 14.34%, but that compared favorably to the fund's benchmark, the Russell 2000 index, which was down 21.58%. He credits this relatively better showing to an underweighting of technology stocks. Satuit Capital Micro Cap's biggest holdings now are in energy, with stocks such as Brigham Exploration (BEXP
), Offshore Logistics (OLOG
), and Tesco (TESOF
).
These were some of the points Sullivan made in an investing chat presented on Jan. 9 by BusinessWeek Online on America Online, in reply to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.
Q: We've had an encouraging start to the new year -- do you expect the broad market to continue to make us happy?
A: I think that as equity investors, we're going to be pretty pleased with the returns that we get this year. However, I would caution investors not to expect the same kind of returns that we saw back in the late '90s. My sense is that we're going to get back to more normalized equity market returns, somewhere between 8% and 12% on an annualized basis.
Q: Can you update us on how your fund fared last year?
A: The fund ended the year down 14.34%, and that's vs. our benchmark (the Russell 2000), which was down 21.58%. As I mentioned in our annual report, which will be up on our Web site in a few days, our outperformance of the Russell 2000 was reflective of what we didn't own in 2002. We were underweighted [in] technology, and for the most part that helped drive the return differential between the fund and the benchmark.
Q: Speaking of tech, do you like either SanDisk (SNDK
) or OmniVision Technologies (OVTI
)?
A: Let's start with OVTI. They are a holding of the fund -- owned it for quite some time, one of our best performers in 2002. A fabulous semiconductor company that designs chips for digital cameras, surveillance systems, video games. We like it because we think that the end markets are going to grow going forward. SanDisk is $1.3 billion of market cap, a little too big for our fund.
Q: Bob, what micros are good values right now?
A: An interesting little company that we own as a true asset play is the Providence & Worcester Railroad (PWX
), a little short line from Worcester, Mass., to Providence, R.I. -- carries industrial materials, has a fiber-optic cable running underneath the train tracks, from which they collect a small royalty. What's interesting is the property that they own at the end of the line in Providence -- a terrific little asset.
Q: You said your fund underweighted tech -- what sectors have more weight and/or are doing better?
A: Right now, our largest sector weighting is in energy -- probably 21.2% of the portfolio -- concentrated in domestic natural-gas exploration and production, and services. I've tended to stay away from oil and oil services because of the Middle East.
Q: Can you name some of your favorites in the energy or natural-gas area?
A: Let's start with a new holding, which is Brigham Exploration -- a small company that uses 3-D seismic imaging and explores mainly in Oklahoma and Texas. Another that I like is Offshore Logistics. They own a fleet of helicopters that transport supplies and crews back and forth to both onshore and offshore rigs. One that is a little bit dicey, if you will, is Tesco Corp. Tesco has been experimenting with a new drilling technique, which they have patented, called casing drilling technology, which means drilling for oil and gas wells without the use of an actual drill pipe.
Q: The smaller stocks have been outperforming the biggies -- do you think that trend will continue into 2003?
A: I hope so -- I'm a micro-cap manager. But seriously, we've been talking about three very important themes that, as equity investors, we feel we must get our arms around: diversification, valuation, and the economic cycle. As equity investors, our portfolios should be diversified, with large-, mid-, small-, and micro-cap strategies.
Valuations of smaller-cap companies are still very attractive on a p-e to growth basis. And if you believe, as I do, that we are bouncing around a bottom in terms of the economic cycle and that over the next 24 to 36 months, the economy will be stronger, history suggests that the smaller companies that are more domestically oriented will outperform their large- and mid-cap brethren.
Q: If the dividend tax is reduced, will that hurt micros?
A: My sense is that there would be some rotation into companies that pay dividends -- utilities, large pharmas, financials. I don't think, however, that the money would be coming out of small- and micro-cap allocations. Small- and micro-cap companies have historically never really paid dividends, so we've never made allocations into these strategies for dividend and income.
What may happen is you'll see a rotation out of some lower fixed-income securities into equities that are paying dividends.
Q: Name the company with the greatest potential for price appreciation in the next six months.
A: One that is very attractive right here and that could be turning the corner is Ceradyne (CRDN
). Ceradyne is in advanced ceramic applications. One of their business lines sells ceramic applications into military and homeland security. Some of their materials are also in the Black Hawk and Apache programs.
The other piece of their business is in industrial applications, and they're making lightweight ceramic components for combustion engines...one of my favorite stocks in the portfolio.
Q: Assuming a fairly long time horizon and a moderate tolerance for risk, how much of a portfolio would you suggest for micros?
A: We've done a lot of work on that.... Your micro-cap allocation should be somewhere between 15% and 25% of your equity portfolio, depending upon your risk tolerance.
Q: What are the best resources for individual investors to find key financial stats for micro-cap companies?
A: One of the two best sources that I've found for micro-cap companies is sec.gov, and you go to the company filings. You can get all the financial filings from a company online, and it's getting very easy to use.
The second place, quite frankly, is the company's Web site. Some of these companies have terrific Web sites, great information about products, the industry, their customers, their competitors. And if you call the company you can usually get information straight from them. These companies are so small that they'll talk to you.
Edited by Jack Dierdorff
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