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Get Four
|  | FEBRUARY 2, 2006
A Small-Cap True BelieverMany expect large-cap stocks to be outperformers in this economy. But fund manager Mary Lisanti tells why she doesn't see it happening"It's a goldilocks economy for small companies -- it's not too hot and not too cold." So says small-cap veteran Mary Lisanti, president of AH Lisanti Capital Growth and manager of the Adams Harkness Small Cap Growth fund (ASCGX ). Though many pros on Wall Street have been predicting that large caps will finally overtake small stocks (see BW, 12/26/05, "The Bulls: Pawing and Snorting"), she still thinks smaller is better. Small companies have stronger earnings growth, rising margins, and pricing power -- a recipe for higher stock prices that's lacking for many large companies, Lisanti contends. Indeed, small caps have been trumping large stocks for the last six years and keep pulling ahead. The Russell 2000 index, a widely used barometer of small companies, rose 16.73% in the last 12 months through Jan. 31. And it's up 8.91% since the new year began. That compares to the large-cap S&P 500-stock index' gains of 7.62% in the last 12 months and 2.55% so far this year. Lisanti's fund has beaten her benchmark, the Russell 2000 Growth index, since it was launched almost two years ago. In 2005, the portfolio gained 14.18%, vs. a 5.66% gain for the average small-cap fund. "The process I've used [for] 13 years does well in good markets, and we we can hold our own in 'downish' markets," she says. "But it really shines in these kinds of flat, choppy markets, because it's a stock-picker's process." Her fund now holds around 100 stocks, and Lisanti notes that 70 of them tend to power the portfolio. Lisanti recently spoke with BusinessWeek Online's Karyn McCormack about why she's gushing about small companies -- and her fund's top holdings. Edited excerpts from their conversation follow: Do you think small stocks will keep outperforming? I do. I think it comes down to earnings growth. It's concentrated in the growth sector of the market. The Russell 2000 Growth companies are growing earnings at about 25% and selling at about 20 times earnings, so we still have quite a ways to go. In the past couple of years, you have to realize how understated earnings are, and how understated the growth rates are going forward, because many of these companies are taking huge charges since they need to keep paying people with stock. They're also loaded up with Sarbanes-Oxley costs, which is a couple million bucks per company. And they're still growing earnings by 25%. Take that out, and they're growing much faster. Certainly, small stocks keep pulling ahead this year. Usually, you don't change leadership in the market unless you have a major correction. Look at S&P 500 earnings growth: 27% in 2004, 13% in 2005, 6% in 2006 -- that's the issue. It has nothing to do with whether the Fed stops raising rates. It has to do with the fact that even if the Fed stops raising rates, unless earnings significantly accelerate for the S&P, the market is not cheap. Now, it could happen if the dollar continues to go down, because they'll get a benefit from currency, but even that is not high-quality. January has been strong for small-cap stocks. It always is. When January is this good, it's usually a good year (see BW Online, 2/02/06, "January: Good Start, Good Year?"). It doesn't mean we might not have a correction somewhere in the middle of it, because we always do. But this is why fundamentally, I think they will keep running. And I know I'm in the minority, but I don't just see the data supporting a move to large-cap stocks. Yes, I've heard a lot of market watchers predict that large stocks will outdo small ones this year. They said it last year, too. I've never seen stocks go up when earnings growth slows -- particularly when they're selling at 16 times earnings. It's not like we're giving them away. Can you find individual stocks in large-cap land that will do well? You probably can. Is it easier in small-cap land? It is. To say that just because [small-caps' outperformance] hit six or seven years, we have to be done, it's silly. There has to be a structural reason. I just don't see it. In a 2% to 4% GDP economy, which is what we're in, with reasonably low inflation and reasonably low interest rates -- although the secular trend for interest rates is up -- the rate of earnings growth is really what's going to determine the return on investment and to shareholders. Quite honestly, I think the market is going to go where the earnings growth is. Because increasingly, we're starting to realize that what's going on here is secular, not cyclical, and what's scarce is earnings growth. Don't you take more chances with smaller stocks? The risk with small caps is their ability to execute. That's what drives all of us crazy. If we could see with perfect clarity at the beginning of the year who was going to execute and who wasn't, we'd all be multibillionaires. More and more, we're finding companies, where not only are their fundamentals improving, but they've brought in new management. And they've implemented technology and they've pared back costs, so you're getting a double whammy. What else is driving small companies' growth? I think everybody is going to be wrong in assuming revenue growth is going to slow. At the companies we talk to, the opposite is happening. That's because, finally, the world is getting more confident. That means people are spending and businesses are starting to spend. Margins are continuing to go up -- this is where I think the big surprise will be. Everybody assumes that margins for smaller companies won't go higher because they're close to the peak, especially for the small banks which probably have peaked their margins. But the rest of them are just starting, and they're going to pass their previous peak in margins. You see it most clearly in retail, where they've changed almost every management team in the small- and midcap retail area. The net result is they've all gotten better. You can go through them, from American Eagle (AEOS ) to AnnTaylor (ANN ) to Gymboree (GYMB ) to Children's Place (PLCE ), and the story is the same. They're running their businesses better, and then they get a little pickup in their revenues and it falls exponentially to the bottom line. Or if you get a 5% to 10% pickup in corporate spending on say, networks, Cisco (CSCO ) will get its share, but it will also fall disproportionately to smaller companies like Foundry (FDRY ) and F5 (FFIV ), which have very strong products. It's just the beauty of being small. How do you find stocks? We do a lot of screening to see what's going on in the world. We know we're in a bull market for small caps when we find 600 or 700 companies that meet our screens. We're still finding 600 or 700. In a bear market, you'll find 200. What are some of your fund's top holdings? Our top holdings are companies like Hologic (HOLX ) -- that's typical of the kind of company that we find. Hologic is in a very strong new-product cycle -- that's really what's driving their busines. They do the 3D analysis for the breast so can detect cancer much earlier and prevent it. That's going to go on almost irrespective of the economy; they're sort of in their own little world. Another one is Redback Networks (RBAK ). It came out of bankruptcy a few years ago. They were one of the Class of 2000 that busted. It radically redid its cost structure, has new management from Cisco, and has very good products. It's sort of in the sweet spot. Psychiatric Solutions (PSYS ) runs mental-health faciliites. They're benefiting from the fact that they're much cheaper than the hospital in-patient facilities. Actually, the Medicare changes are benefiting them. And it's a consolidation story because there are a lot of mom-and-pop operators in the business. Again, it has a very experienced management team. LCA-Vision (LCAV ) is where you go to get your eyes fixed if you do the laser thing. It's got a very experienced management team. We have a little insurance company called Argonaut (AGII ). I love it. It's a turnaround. New management came in a couple of years ago. They focus on small-business lines. It's very profitable, and growing very quickly. They had a reinsurance business that they had to fix. Now that they've fixed it, they're actually seeing the underlying growth in the business. So you have no shortage of ideas. I can find them everyplace. We probably have a better class of small companies that we've ever had, really, since the mid-70s. It's a goldilocks economy for small companies -- it's not too hot, and not too cold. They're getting pricing power. This is the other trend we're seeing -- this enormous consolidation and they're getting pricing power. So many of the companies we talk to are able to raise their prices, whereas the bigger companies have more trouble. Are you a long-term investor, or do you trade? We do trade. Our average turnover is about 200%. That comes from the fact that we have a pretty strict valuation discipline. If a company starts to sell at or above its growth rate, on 12-months out earnings, we sell it. There's too many of these companies, and they don't execute perfectly. When they're selling at or above their growth rate on a price-earnings basis, people think they're going to execute perfectly. So the first little mistake, the stock falls apart. We're not going to going to take that risk. The other thing we like to do is, when the markets are down, I love to go shopping. When the market corrects, we will trade up in quality. That's actually what we did last spring, which what was so helpful to the portfolio all year. We took the growth rate of the portfolio from 30% to 45% without budging the p-e at all. Then it became like a coiled spring and off it went, as soon as the world got a little more sane. What advice would you give investors, particularly when researching stocks? If they go on the company Web site, they can get an enormous amount of information. I think that in terms of doing it yourself, I'm of the Peter Lynch school, which is stick with what you know, or where you have some experience or expertise. Then, because most of them won't follow them every day and they won't have the time to spend on them that professionals do, buy them when nobody wants them. The other thing to recognize is there is real skill in managing companies. We're now at the point where we can see those who have it and those who don't. I always like to read the annual letter to shareholders -- companies post them on their Web site -- because it's their most important tool to communicate with you. The last piece of advice is what my father gave me, which is, if you double your money, take half out and play with the market's money. But always try to protect your principal. It's a form of risk control. This way you haven't lost anything. If you have a long-term outlook and you're careful about when you buy them, that's when you do the best. 
BW MALL
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