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For stocks both large-cap and small, 2000 is turning out to be a lackluster year. The large-cap steamroller called the Standard & Poor's 500-stock index has shuddered to a halt, and there's even a possibility that large caps could finish the year down for the first time since 1994. At the other end of the market, the lesser names tracked by the Russell 2000 are off 1.9% year-to-date.
That hasn't fazed John Hancock Small Cap Value fund (SPVBX) portfolio manager Tim Quinlisk, who specializes in finding small caps that are undervalued. Quinlisk's choices have performed well in 2000, outpacing his fund's benchmark, the Russell 2000. As of the market's close on Oct. 4, John Hancock Small Cap had rung up a 2.6% total return. And despite carrying a 5% cost load, Quinlisk's fund has managed to outshine all comers in Morningstar's ranking of small-cap funds that blend growth and value investing strategies, with a 29.6% average annual total return over the past three years. That compares to the 10.2% average annual total return posted by Vanguard's Small Cap Index, which tracks the Russell 2000.
Quinlisk says there are opportunities in small caps because investors have been so choosy when it comes to the market's smaller offerings -- generally, companies with capitalizations of $2 billion or less. They have avoided dot-coms and dicier technology shares and stuck to companies with clear business plans and steady growth. But in the process, they have bypassed some good prospects. Notes Quinlisk: "There are a number of good businesses, especially in the service sector, that are down 60% to 70% for the year, in some cases, with no change in fundamentals."
LOWER PEG. Even though the John Hancock fund has the words Small Cap Value in its title, Morningstar includes it in its small-cap blend grouping, a category whose funds straddle the growth and value camps. That's because Quinlisk isn't a strict play-it-by-the-numbers value guy. "Our philosophy differs from the traditional value line because we're trying to find great businesses when they go on sale," he says. "We're looking for a good value with added characteristics -- high returns on invested capital, good free-cash flow, and, ultimately, some catalyst that will unlock the value we've found."
So while Quinlisk may start off screening the small-cap universe for companies that have been sold off or are fetching a price-to-cash flow that trails that of their industry peers, he still places plenty of emphasis on revenue and earnings growth. That's why Quinlisk emphasizes a stock's p-e to earnings growth ratio -- or PEG -- when he's scouting for holdings. The lower the PEG, the better, from his point of view. The PEG ratio is normally a yardstick used by those who adhere to the growth school of investing, but Quinlisk uses it anyway.
His approach "isn't hard and fast, but as far as initial reads go, I would say we start to get interested at a PEG in the ballpark of 0.8," he says. Even so, "I'm still a value manager at heart," he adds. "In the end, the growth managers are going to key in on growth, and we're still focused on value."
One of Quinlisk's largest positions this year has been Vicor (VICR), which makes power components and converters that are used on circuit boards in telecommunications equipment. In 1998, Vicor introduced its second-generation power converter and began to ramp up capital outlays to boost production capacity. Earnings slowed, and Vicor's stock begin to hibernate. By the first quarter of 1999, Quinlisk judged the time to be right and jumped in. Subsequently, the stock appreciated 350% in 1999, plus an additional 10% so far this year. Quinlisk, whose average purchase price for the stock was 19 13/64, thinks Vicor will hit 75 over the next 12 to 18 months, vs. its Oct. 11 close of 43 13/16. In fact, he believes that the market still hasn't accepted the idea that Vicor should produce revenue growth of 30% to 50% annually over the next three years.
PROMISING SIGNS. Another winner for Quinlisk has been Corinthian Colleges (COCO), a company that operates 45 private, for-profit campuses across the country. Corinthian offers training and diploma programs for computer technicians, dental and medical staff, and electricians. Quinlisk says he started buying Corinthian shares in March and April, and paid an average 16 45/64 for the stock.
"This is a very good business with a clean balance sheet and lots of free cash flow," the fund manager says. "As an education company, it enjoys a fairly predictable stream of earnings and is not dependent on the economy. You might even say it's countercyclical, since enrollment could pick up if there's a slowdown." Corinthian is up 152.5% year-to-date and 106.4% in the past three months alone. The stock, which closed on Oct. 11 at 58 1/8, has bumped up against Quinlisk's target price in the "high 50s." The fund manager says that while he'll hold on, he isn't devoting new funds to his position.
Quinlisk also thinks highly of A.C. Nielsen (ART), the media and market research firm that was spun off from Dun & Bradstreet in 1996. Over the past couple of years, Nielsen has spent heavily to get tracking systems for e-commerce and Internet ratings up and running. "They're the dominant market-research firm, with a unique data-measurement franchise in the U.S.," says Quinlisk, who expects the company's investments in America plus a major restructuring in its European operations to pay off big soon. At its close of 22 3/4 on Oct. 11, Nielsen, which is down about 3.5% so far in 2000, trades at 16.8 times estimated 2001 earnings.
Taking into account Wall Street projections that the company's earnings should increase at a 24.8% average annual clip over the next five years, as calculated by Zacks Investment Research, the stock's PEG is a slim 0.68. Quinlisk thinks the company should post revenue growth of 8% to 12% annually over the next two years and reach a target price in the low 40s.
A number of signs point to further upside ahead for small-caps. Steven DeSanctis, a research director at Prudential Securities who follows small- and mid-cap stocks, says the small fry can look forward to 18.1% earnings growth in the third quarter over year-ago figures, vs. the 16.8% increase he's projecting for the large caps. But while small caps have typically fetched a premium of about 3% vs. p-e multiples of large caps, the small-cap segment is presently selling at about a 25% discount. "People are now more focused on valuations, so small-caps have begun to gain a lot of attention," says DeSanctis.
Quinlisk agrees with that assessment. "Right now, small-caps still look very interesting compared with the large-cap group," he says. "They still have very attractive valuations -- good, solid franchises at good prices."
Anderson teaches journalism at the City University of New York
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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