Businessweek Archives

Small Caps: Still No Cap In Sight


Investing in 1994: SMALL CAP STOCKS

SMALL CAPS: STILL NO CAP IN SIGHT

At a time when overseas markets are leaving the U.S. in the dust, only one strategy seems sure to pay off handsomely: Think small. Small-capitalization stocks were the standout performers of 1993. Driven by a hot initial public offering market and undeterred by a falloff in health-care issues, secondary stocks handily beat the overall market, climbing 14.1% in the year to date vs. 6.9% for the Standard & Poor's 500-stock index.

Will this strategy continue to pay off for investors in 1994? That's a dicey question because small caps are among the most volatile segments of the stock market. But the answer is decidedly affirmative. All of the fundamental factors that were present at this time last year, from modest valuations to a healthy but not overheated influx of mutual-fund cash, are continuing to drive the market for secondary stocks.

PRICE PRESSURE. The case for small caps as a market-cycle phenomenon is equally compelling. "There's no risk to the cycle coming to an end in 1994--so long as valuations stay good," remarks Claudia E. Mott, a quantitative analyst at Prudential Securities Inc. and a leading small-cap guru. The valuation numbers are certainly encouraging: Price-to-earnings and price-to-book ratios of small-cap stocks, as compared with large stocks, are actually below their long-term average, according to the number-crunchers at Prudential Securities. And the great enemy of small-cap rallies--overoptimism--remains in check. Mutual-fund cash levels among small-cap-oriented "aggressive growth" funds, which dropped to a troublesome 7% in September, climbed above 10% in October, the most recent month for which figures are available.

The fund numbers bear close watching. But so long as a tide of bearishness continues to tug at the small caps, the rally should continue. Indeed, secondary-stock watchers such as Mott, who were strongly bullish on small stocks a year ago as well, are seeing their predictions resoundingly vindicated.

A sector-by-sector breakdown of the small-cap universe illustrates the broad-based character of the small-cap advance (table). According to Frank Russell Co., only 2 of the 12 categories in the Russell 2000 index, the leading small-cap barometer, declined during the year. One drag on the small caps was the health-care sector, which makes up a hefty 13% of the index. Health stocks were decimated by the fallout from Clinton's health-care plan. The other main area of distress was the consumer staples group, encompassing food, beverage, tobacco, and other noncyclical stocks, many of which did poorly during the year. But the malaise in consumer stocks and health care was offset by a rally in technology stocks, which make up some 14% of the small-cap gauge.

A resuscitation of health-care stocks--or at least the ones excessively punished by the market--should help drive small caps in the year ahead. Ditto for continued low interest rates, which should keep spurring the utilities and financial-services stocks that make up a large segment of the small-cap universe--6% and 19%, respectively. That makes small stocks almost as interest-rate sensitive as large caps, which are about 30% utilities and financial companies.

HIGH CONCEPTS. In fact, small-cap stocks are a happier hunting ground than the biggies for investors seeking to cash in on disinflation. Small regional banks receive notoriously little analyst coverage, making them a particularly ripe field for savvy investors. The virtues of small-cap stockpicking are further borne out by the stellar performance of small stocks that don't fall into any particular category. The "other" segment of the Russell index climbed nearly 25% through Nov. 30. That is the repository of the "niche" companies that are not widely followed by Wall Street analysts and are the mother's milk of small-cap stockpickers.

Niche investing is likely to continue to pay off handsomely in the months ahead. True, stockpicking can be a touchy exercise when stocks are climbing past their all-time highs. Timothy Evnin, a small-cap portfolio manager at U.S. Trust Corp., observes that finding good values has been getting a lot tougher in recent months. But he has found solace in obscure insurance companies such as Capsure Holdings, a Chicago-based underwriter of liability and property insurance 30%-owned by noted investor Samuel Zell.

Another insurer that tickles Evnin's fancy is Integon Corp., which writes "nonstandard"--high-risk--automobile insurance in the Southeast. Both are strong companies with stellar growth prospects. Likewise, he is buying shares in Xyplex Inc., a computer-networking company with a cash-rich balance sheet that is selling at only 13 times recent earnings. Evnin has taken profits in such hot stocks as Grand Casinos Inc. and Acclaim Entertainment Inc., which are now selling at price-earnings ratios of 30 and 35, respectively.

Stocks such as Xyplex represent the low-priced opportunities in the small-cap market. The polar opposite of the value stocks are those in the often-frothy IPO market, many of which are what veteran small-cap manager Richard L. Thorsell scornfully refers to as "concept stocks"--as in the "concept that [recent IPO] Boston Chicken will grow to a million outlets."

STRONG AND SILENT. Thorsell, who runs $400 million worth of portfolios at Thorsell, Parker Partners in Westport, Conn., finds far more appeal among low-visibility stocks such as regional banks. They are, he notes, frequently acquisition targets--usually at twice book value--and can commonly be bought at 1 1/4 to 1 1/2 times book value. But you have to scour the countryside to find out about well-priced regional banks such as Deposit Guarantee National Bank in Jackson, Miss., West One Bank in Boise, Idaho, and First American National Bank in Nashville. Says Thorsell: "I think you're going to see a 20% to 25% move in some of these banks."

Thorsell is also moving money into bedraggled health-care stocks, retailers, and--despite the runup there--technology. His picks include Merry-Go-Round Enterprises Inc., a Joppa (Md.)-based retailer, and Fisher Scientific, a laboratory-supply manufacturer trading at 33, with a p-e of 18, which Thorsell expects to rise to as high as 45 in the next 6 to 12 months. He recently took a substantial position in Exide Electronics Inc., a leading manufacturer of uninterruptible power supplies for computers. Exide is moving into small-size computers that are becoming more popular. It's trading at 16--less than 10 times its estimated 1994 earnings, which Thorsell expects will hit $1.70 a share.

Companies such as Exide are representative of the great silent majority, so to speak, of small-cap stocks. They are exciting in a way that has not caught on with investors generally. In the year ahead, that's the smartest way of catching on to the small-cap rally. The pitfalls in small caps, such as frothy IPOs, are surely out there. But so long as IPO-style madness remains restricted to the new issues, small-cap stocks will avoid a nervous breakdown.Gary Weiss in New York


Best LBO Ever
LIMITED-TIME OFFER SUBSCRIBE NOW
 
blog comments powered by Disqus