Looking for a play on the entrepreneurial economy? Consider big public companies that serve small private outfits

Buy what you know: That's the conventional wisdom for investors. But it's dangerous advice for an entrepreneur. Follow it too literally, and you'll will wind up buying stocks of small, risky companies, which is the last thing a business owner needs. You already have one of those, remember?

Still, you know a lot about what makes a small company work — from payroll services to financing to technology. So a safer way to capitalize on your knowledge and build in some diversity would be to invest in bigger companies that serve the needs of your business — along with thousands of other outfits like it.

It's a fast-growing market. Small businesses created 80% of the new jobs from 1992 to 1996, and they account for about half of the country's gross domestic product. "This is a very vital segment of the economy," says John Schreiber, an assistant portfolio manager at Janus Funds who keeps his eye on small-business plays. "Companies that can help this new generation of entrepreneurs help themselves are in a sweet spot in the economy today." Just look at Staples Inc. Once, the office-products store was simply a place to stock up on printers and paper. Now the savvy megamerchant offers payroll, Internet, and telecom services to small businesses. It's opening shops in airports and offers 24-hour service in many locales.

This is not to say that any company serving the small-business market is a wise investment. When we first looked at this category back in June, 1998, we found 23 companies that targeted the small-business market. The list has since grown to about 35. But many of these are small-fry companies with shaky financials, and some on the original list have belly-flopped in the past year.

What looks good now? We narrowed the list to include only mid- to large-cap stocks, which is to say those with market caps of over $500 million. Then we looked for strong earnings, decent valuation, and above-average growth potential. The results won't surprise you: Those on the list are leaders in their fields and have long track records of being able to anticipate the ever-changing needs of small businesses.

The super store. It's hard to argue with Staples' (SPLS) phenomenal record. In the past five years, the company has posted annual earnings of at least 30%, and analysts see no sign of a slowdown. In fact, the Janus Funds are so enamored of the company's prospects they recently increased their holdings — and now own 9% of the company, making them one of Staples' largest shareholders. What's driving this growth? The company is expanding its store base by 20% a year and continuing to add services needed by small-business people and home office workers. What's more, the company's e-commerce business, Staples.com, is taking off and is planning to ring up sales of $1 billion by 2003. Considering the steady expansion plans in both the physical and cyber worlds, Schreiber at Janus expects earnings to grow 30% annually, and the stock should triple in three years.

The paymaster. If track record counts, it's hard to beat Paychex Inc.(PAYX)  in Rochester, N.Y., the aggressive payroll-processing company. Started by B. Thomas Golisano, the company had one employee and 40 clients in 1971. It now claims 330,000 customers nationwide. Paychex has made the most of its broad market share. In the past decade, the company has added tax-payment services, direct deposit, check signing, and, more recently, 401(k) record keeping. All of these have paid off handsomely. In the past eight years, earnings have grown by about 36% annually, and analysts expect they'll continue rising 28% annually for the next few years. Kristin Gamble, president of Flood Gamble Associates Inc., a New York investment firm that has owned the stock for the past decade, expects the shares to double by 2002. "CEO Golisano is a good thinker and a great leader," she says.

The creative lender. Perhaps the greatest challenge for any small business is to keep the cash flowing and the company growing. That's where Allied Capital Corp.(ALLC) steps in. The 41-year-old Washington (D.C.) finance company is, according to CEO William L. Walton, "not a typical lender. We provide capital a lot more creatively than banks." For instance, Allied often takes a small ownership position in the companies it finances — giving you an indirect stake in many other small, private companies — and provides management assistance as well. An exhaustive due-diligence process has kept the company's loan-loss rate at an impressively low 1%. Allied used to be five separate companies, but in 1997 they were merged into one. "That made a world of sense," says George Chelius of the fam Value Fund, which owns a 5% stake in Allied. "It made the company more efficient and easier for Wall Street to track." The company's average annual return has historically been about 19%, but since the merger it has moved up to 26%. The stock is well off its high after a secondary stock offering this summer, but with 15% growth rate and a fat 7.8% yield, Chelius says, "this is an excellent value play."

By Lesley Alderman in New York


Click here for a more complete list of publicly held companies that serve the small-business market.

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