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After being widely ignored for most of the 1990s, small stocks are the popular kids on Wall Street lately. The S&P 600 index of small stocks is up 3.6% year-to-date (through July 20), while the S&P 500 index of large companies is down 8.3%.
Marcus Robins, editor-in-chief of the Red Chip Review and a specialist in picking small-cap stocks, thinks money will keep flowing into the group -- even with the uncertainty in the market about when economic growth and corporate profits will recover. His main reasons: lower interest rates, improving liquidity, and a change in market leadership. Among Robins' favorite stock picks are Advanced Marketing Services (MKT
), Exponent (EXPO
), and Measurement Specialties (MSS
Robins made his comments during a chat July 19 presented by BusinessWeek Online on America Online. He was answering questions from BW Online's Amey Stoneand the audience. Edited excerpts follow. A full transcript is available from BW Online on AOL at keyword: BW Talk.
Q: Marc, what is your view of the market? Seems like we're getting a lot of mixed signals lately. Are you in the bull or bear camp?
A: I'm in the bull camp. And mixed signals is precisely what experienced market watchers would expect at this juncture. You are facing, on one hand, lower interest rates, improving liquidity, and expanding market multiples -- due to monetary policy -- juxtaposed to slowing earnings, due to the flagging economy.
In fact, things would be not natural if we were to have diminishing interest rates and increasing earnings at this very juncture. Indeed, this is what happened in the early '80s, and it led to a whole new round of Fed tightening, which led to a far more hurtful recession.
The Fed policy leads market action, which leads economic action by 6 to 12 months. The Fed has been doing its thing since the beginning of the new year (late 2000, early 2001). There are some market crosscurrents, both up and down, and indeed we have seen less problematic economic results. I'm quite bullish -- for the reasons stated and also because we have seen a change in leadership.
Q: I have heard that RCR follows Sciclone Pharmaceuticals (SCLN
). What do you think of the company and its future?
A: We remain quite optimistic about the company's long-term prospects. As a fellow shareholder, no one can be more disappointed at the fact that the shares have fallen from the 20s to the middle single-digits.
But the same formula for success seems to be in place for SCLN as it was with Celgene (CELG
) before it ran to $200: Its No. 1 drug should address a 300-million-person population -- Hepatitis B and C doesn't have any clear cure -- and they have an array of other science, which has interesting upside. Right now, it has revenues, it's about cash-flowing research and its trials, and I think next to Vivus (VVUS
), it is my most fond pharmaceutical.
Q: How do you analyze a company? What do you consider a small cap stock?
A: Red Chip has established its reputation as being an old-fashioned special-situation GARP [growth at a reasonable price] research house. We're looking for unique companies that have a differentiated and distinctive product, service, or brand edge....Given fundamental research, we decide if the shares are cheap, or too expensive, based on their relative growth rate vs. p-e multiple.
I personally like to find special situations that actually are priced well below their growth rates: A stock that is growing at 25% that I can find at 10 times current earnings, or at book value. So I guess there's a little value investor in me, even after all these years.
Regarding small-cap stocks: Take it for granted, that term has changed over the last 25 years. I still think it's fair to say that a small cap ranges between $100 million and $1 billion in market capitalization.
Q: There is so much artistic nature in finding a stock that is undervalued. How do you find those intangible qualities that make a company special?
A: Other than being able to qualify a superior management out of the haystack of mediocrity, that's one of the toughest questions there is. Forgive my braggadocios stance, but that answer comes partly from the fact that we've played in the sandbox professionally for 25 years, and as an active investor for 35 years. Now all pompous remarks aside, we really do three things to sift much of the wheat from the shaft.
First, because we follow nearly 30 industries, we have a pretty good perspective on those companies that are fighting the good battle in a very competitive realm, vs. those that are truly distinctive.
Second, we look for above-average profit margins, or competitive angles that give the special-situation company the ability to earn above-average returns. (My favorite example of this was Hyster Company vs. the rest of the lift-truck industry, including Clark Equipment, back in 1982. Despite Hyster being one-fifth the size, it had double the return on equity -- and profits to sales -- than the industry leader. So, that was truly a special situation in a crowded arena.)
The third true signal of a distinctive special situation is the owner profile. We really want managements to own more than their fair share of the stock outstanding vs. the market. We also want institutions to be really quite ignorant of the companies' abilities.
This provides two benefits. If the shares aren't held too centrally, say by a few family members, it really maintains that uniquely American quality of entrepreneurism. We want that in spades.
On the other hand, we can help institutions learn more about a neat opportunity and, ultimately, in the small-cap world, these ponderous buyers will bid up the price to our subscribers' benefit. A perfect example of that was Iomega (IOM
) at $0.89 in '96, Medicis (MRX
) at 6, and Measurement Specialties at 2 3/8 in 1998.
Q: Marc, now that you've shared all your secrets with us, how have your returns been -- both long and short term (recognizing of course the tough markets in the past year or more)?
A: All kidding and pomposity aside, I'm really glad you asked that question. As measured by our top picks, our 1999 returns were up 52%, vs. the Russell 2000 of 16.7%. Our 2000 was up 26.9%, vs. 3.5%, and our YTD is up 23.26% (through June 30), vs. 15.5%.
I have to say that I know we have been most fortunate over the last four years. But we have finally been found in the right place at the right time after almost 16 years of being out of favor. So, it's a combination of finally standing out in the middle of the rain when the clouds part, as well as just doing the job we all like to do -- that is to find stocks that go up.
Q: Is Red Hat (RHAT
) a viable threat to Microsoft (MSFT
A: Can't answer specifically. I think Microsoft may just be overturned because of its hubris. It's had an awfully long run and a series of opponents nipping at its heels. I just can't help believe that it isn't time for some other software capability to dislodge it some.
Q: Any opinion on Three-Five Systems (TFS
A: Yes. Interviewed the CEO today for our Red Chip Radio Sunday morning program. I have followed this company since it went public, and have watched its ups and downs and problems and discoveries in the telco field. I really was quite impressed with the company's ability to overcome the current downturn, and believe that if it isn't close to a bottom, we're within a month or two of the low point for this cycle.
This is exactly the time that investors ought to be looking at this company's strong balance sheet, strong customer presence, and the opportunities facing it due to newly developed technology. I personally don't care for it so much because it is more of a commodity supplier, but I was wholly impressed by what I learned today in comparison to past experience with that company and stock.
We have it ranked as a "B", with a $40 long-term target. I think that sums up the position pretty well. I would not create a full position here, but I'd be nibbling.
Q: What are your favorite stock picks?
A: For the more conservative small-cap buyer I think Advanced Marketing Services is really a very good long-term hold stock. For youngsters that need to pay for college education, or oldsters who want to protect themselves from inflation (or add growth to their portfolio), this is a perfect 20-25% earnings grower ad infinitum.
For value players, I like Exponent at this level. It is one of the country's engineering brain trusts that historically has focused on analyzing failures. But it has now taken its cross-discipline expertise, and focused on solving Defense Dept. equipment problems -- such as Land Warrior. I think there's a lot more growth opportunity as it shifts its business from a legal-consulting entity to a product-creation and problem-solver entity.
I really like MSS (Measurement Specialties). The stock's down from 26, and should see at least that if not 30s in 18 months. And lastly, I like Vivus, as it addresses the side effects of Viagra -- the unaddressed market of premature ejaculation, and female sexual dysfunction, all market opportunities larger than the $1.5 billion Viagra market.
Q: Should we go international -- in particular, Europe?
A: I'm not qualified to answer that. Why bother going overseas when our economy has bottomed and should be turning up. We have a wholly better understanding of our own accounting laws and we have, quite honestly, superior technology in most -- if not all -- scientific fields. My playpen is certainly big enough for me.
Oh, one last thing....As I mentioned earlier, in 1998 we ended a 16-year large-cap rally. I think, as the numbers I gave earlier show, that we could be in a multiyear small-cap rally -- and historically, that runs around eight years. If the large pension funds really started to shift assets to the small-cap arena, it would still take them five years to take full positions -- and that's not an improbable scenario.
Q: Do you manage money, and do you have any thoughts of starting a mutual fund?
A: I started Red Chip in my basement in 1992, and it was my effort to evade a noncompete clause in my employment contract. I had every intent of starting a fund, because we were doing original primary research.
But we've been so doggone busy publishing we haven't found the time. Now, our parent, FreeRealTime.com, has declared bankruptcy, and I can only tell you that new things are afoot. I think I'll be able to tell you much more in another several months. In the meantime, we'll continue to focus on our recommendations, our conferences, our radio show, and our newsletter.
Q: Glad to hear your business is still holding up despite problems at your parent company. Which makes me wonder -- are there any battered dot-coms in your portfolio? I have a hunch that you might not have played in the dot-com sandbox.
A: Oh no, I played in the sandbox and my hand found a very hot coal, and was burned. Right now, I'm finding a lot more values in medicine, some technology, and basic industry.
Q: In what sector or sectors are you currently finding the most value? You sort of just answered that, but maybe you could elaborate a bit more.
A: That's a very easy answer. The best values -- but not the best investments right now -- are chip production, telco, and other electronic technology. Interestingly, we've had some of our best discoveries in the same field.
Q: When do you think the chip and telecom industries will turn around? Right now the outlook looks pretty bad still.
A: I think the telco -- and by telco, I mean cellular phone -- business will turn before the chip business. We've pretty much saturated the computer arena for the near term, and I think we have more inventory and usage to work through.
On the other hand, new cellular communication systems and technological advances should prompt a quicker demand response by society. I think we could actually see an improving tone to the telcos by the fourth quarter, but not until early next year in the PC arena. That's why I really have liked the sensor business.
We have turned just about every appliance and fixture in our homes into computers that have more power than the first PCs (I mean specifically the TRS-80). The thing that we have forgotten is that computers are nothing but dumb boxes without a keyboard or a mouse, or something that tells the box to do things -- to process information.
Moore's law talks about the doubling of computer power every 18 months. Robins' law believes the demand for sensors will quadruple every 18 months. Stocks like Measurement Specialties, BEI Technologies (BEIQ
), and DuraSwitch (DSWT
) create different input systems that allow computers to help our lives.
What's really neat is that these companies have margins now two and three times the size as the box manufacturers. And they have such a head start in tech, they probably have three to seven years of a competitive advantage to boot.
Q: Since you pointed to chip and telecom stocks as good values, which ones should we accumulate?
A: Well, I honestly think TFS is cheap. I like Oak Technology (OAKT
) and Supertex (SUPX
Q: What new developments are worthy of investment that are coming out of the biotech arena?
A: I'm glad you asked that. I really think that what's going to be hot in the next three to five years in the medical arena is not what new genomic discoveries might be made, but how we can produce these wonder drugs in sufficient quantities to satiate the demand created by our population. In the last couple of years, some stocks went crazy because they could help pharmaceutical firms discover more drug candidates.
Now the bottleneck is how you process a swimming-pool amount of brew into a dribble of valuable drug. I personally think separation technology is one area that needs more exploration. I don't have any really good investment ideas at this point, but I know it's an area that the biotechs and the drug companies are falling over to help proffer new solutions.
One idea, which I own but would not recommend, is a company out of California, called Sepragen (SPGNA
). It's an operating disaster, but extraordinarily elegant technology. I want everyone to know that my opinion is biased.
Q: Well, I'm not sure that's the best note to end on. Any final, more upbeat words of wisdom you want to share with us?
A: I am wholly convinced that the money tide in the market is shifting out of the media- and brokerage firm-favored companies and flowing into the smaller public companies. Satya Pradhuman [director of small-stock research] of Merrill Lynch calls this tide effect the Domino Effect.
And essentially, like the tides, money will move from one shore to the other. In 1999-2000, with the high of Microsoft, was the ebb tide of cash flowing into the high-profile names. Ever since then, we've seen mid-, small-, and micro-cap stocks perform, on the whole, much better. This is a secular trend, and these kinds of flows last for many years.