Investors Should "Not Sit Tight"


Right now is an "incredible opportunity" for investors to look over their portfolios and "make sure that you are diversified, so that you will have the opportunity to make the highest returns for the lowest amount of risk going forward." That's a key piece of advice given by Robert Sullivan, portfolio manager of the Satuit Capital Micro Cap Fund. He suggests investing in a wide range of stocks but sees micro caps (in the case of his fund, stocks with market capitalization of $500 million or less) well set up for a recovery.

Thus he rejects the option of sitting tight. In the microcap area, Sullivan looks for stocks with lower price-earnings (p-e) ratios and above-average growth in earnings per share. His fund, launched at the end of 2000, gained 38% in 2001 -- but so far this year is down 17%. The problem, he says, is there has beens "no place to hide" this year.

Among the sectors he sees as promising are health-care information technology (with stocks such as IDX Systems), military systems (Orbit International, for example), and consumer cyclicals such as Electronics Boutique.

Sullivan made these comments in an investing chat presented Oct. 3 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Rob, before we delve into smaller-cap stocks, the macro picture keeps changing, day to day. When will this seesaw pattern (and downward direction) change for the better?

A: I wish I had some kind of better feel for that. However, I would say that at least it's a seesaw picture, not a straight downward picture. We've gotten all the negative news, and we've been seeing a potential for recovery. And a bottom is in sight. It makes me feel a little bit better about the economy and the general equity market as a whole.

Q: Can you tell us how you comb through the microcap stock universe? What do you consider a microcap, and what criteria do you look at?

A: We first start with $500 million in market cap or less. It's all domestic U.S. securities, and that's our pond.

The first step is a quantitative model we use that tries to filter out companies with higher ROAs [return on assets], higher ROEs [return on equities], lower p-e multiples, lower price to sale, lower price to book. And on the growth side, we look for companies that consistently beat earnings estimates for the current year and are projected to keep going up. The philosophy is to find companies with lower p-e multiples and above-average earnings-per-share growth.

Q: What are some of your favorite microcap stocks? Perhaps some of your fund's top holdings?

A: A couple of the ones that we like: Allegiant Bancorp (ALLE), $263 million market cap, 11 multiple, 13% earnings-per-share growth. A St. Louis bank holding company. Terrific franchise, and should do well in a rising-interest-rate environment, because of the asset nature of their balance sheet.

Another one we like is Daktronics (DAK), $180 million market cap, 14 multiple, 26% EPS growth. Terrific company that manufactures programmable information-display systems. Probably the easiest recognizable products are scoreboards at all the major sports arenas, and more recently on major metro highways -- the LED information signs that you see.

Another one I like is Electronics Boutique (ELBO). It's a $620 million market cap, but the founding Kim family owns 46% of the company. It has an 11 multiple, with 23% growth, and sells video games, hardware, software, and PC accessories at more than 900 stores worldwide -- 85% of sales coming from the U.S. I don't know about you, but my kids aren't asking me for another shirt under the Christmas tree -- they're asking me for another game for the Xbox [Microsoft's game console].

Q: How do you see the prospects for microcaps vs. small-, mid-, and large-cap stocks?

A: Right now, microcap stocks are probably set up as well as they have been in any time, particularly going back to the 1974-82 period, when we saw the beginning of the longest, most dramatic outperformance cycle by small- and microcap stocks in relation to large-cap stocks.

Q: Do any sectors in microcaps look best now, or do you pretty much pick stocks one by one via your criteria?

A: We are bottom-up -- very fundamentally driven, sector-agnostic. And we try to stay away from making macroeconomic calls. Having said that, as I mentioned before, we do have opinions on interest rates and the general direction of the economy. Fortunately, and what makes microcap investing so exciting and interesting, the universe of companies we can choose from is so much larger than our mid-cap and large-cap brethren.

The focus list that we develop...points us to companies that have attractive valuations with above-average potential for earnings growth.... For example, technology is not part of that group right now. We see strength in health-care information technology, and we're seeing a pickup in microcap capital-goods companies. Energy is always attractive, especially the natural gas E&P [exploration and production] companies and service companies, and some of the consumer cyclicals (like Electronics Boutique). And the company GameStop (GME) looks attractive as well.

Q: On sectors, what about pharmas? Any thoughts on small-cap pharmaceuticals?

A: With pharmas, we tend to see in our world these smaller-cap companies that provide R&D services to the larger pharma and drug-discovery services. A couple of examples that we have owned in the fund are Bioanalytical Systems (BASI) and Harvard Bioscience (HBIO). One that we're looking at is BAXS

[Bruker AXS].... The companies that we tend to look at are more service-oriented and driven by the R&D spending of the big pharmaceuticals.

Q: Are you buying any names in the energy area now?

A: Our energy position is about where we want it to be. We are a little bit overweighted vs. the Russell 2000, and I'll give you a couple of names that I think are very attractive: St. Mary Land & Exploration (MARY) -- terrific little gas E&P, 85% gas exposure, probably 60% hedged on production. Another company we like is Offshore Logistics (OLOG). It has a fleet of 290 helicopters that ferry people, parts, and products back and forth to both land and offshore oil rigs.

One that may be a little more risky is TESOF

[Tesco Corp]. It's a company that's based in Canada and has some interesting new drilling techniques that, if adopted by the industry, could provide substantial revenue opportunities for the company.

Q: Aren't you worried about the terrible performance of the mutual-fund industry in the last three years? Which prompts me to ask about the performance of your fund.

A: The answer to the [first] question is yes, you'd better believe I am. I started this fund in December of 2000 -- isn't my timing terrific? Having said that, the performance for our fund in 2001 was up 38%, and that ranked us as the 10th-best-performing domestic equity fund in the country.

Year-to-date this year, as of the end of the third quarter, we were down 17%. We're not doing anything different -- it's just in 2001 we were able to avoid a lot of the disasters. In 2002, it seems as though there's been no place to hide. We continue to buy companies that have revenues, margins, balance sheets, and cash flow, and that have attractive multiples and above-average earnings per share and growth potential.

Q: Why do you think that small caps are suddenly sinking with the large caps? They were doing so well earlier.

A: My answer has to do with the "no place to hide" scenario. If we look at what has been performing this year, we find that it has been gold, bonds, small-cap financials -- a very limited universe of investments.... But, as the old saying goes, I don't want to get into an accident driving my car because I'm looking in the rear-view mirror. What we're trying to do is look forward to identify companies that will provide above-average returns throughout this next market cycle, which we think is going to begin in 2003.

Q: We've heard about stocks you like -- what are you selling? What should investors avoid?

A: Investors should avoid, as we do, companies that have deteriorating fundamentals in terms of earnings. We had sold some of our retailers -- Finish Line (FINL), Shoe Carnival (SCVL), and Ashworth (ASHW), in favor of consumer-gaming electronic firms like Electronics Boutique.

We also rearranged our financial-services positions. The valuations got unattractive to us, which means that the stocks rose in value, so we had to sell them. We actually had a couple of takeouts -- one was VIB Corp. (VIBC). To replace those takeouts, we recently purchased Allegiant Bancorp. I would stay away from technology -- semiconductors and telecom. In my mind, there's way too much capacity, and we won't see any type of pricing for a long time in these industries.

Q: Where in health care would you invest now?

A: In health care, there are some terrific health-care information technology companies out there. We own IDX Systems (IDXC), MIM Corp. (MIMS), and Quality Systems (QSII), to name a few. Also in health care, as I mentioned previously, we're looking at companies that provide services to large pharmas.

Q: Do you like any cyclical stocks, as a way to play the eventual economic recovery?

A: Yes, I do. But let me tell you first where I'm staying away from for the time being. And that's basic industry -- steel, packaging, those types of stocks. I'm waiting until I see demand characteristics changing somewhat.

Where we do see some interesting opportunities is in capital goods, which is somewhat cyclical. We certainly like small military-defense suppliers -- Orbit International (ORBT), Sypris Solutions (SYPR). And there are certainly several terrific companies in the homeland-security area that we've taken a look at, [including] Verint Systems (VRNT) and Drexler Technology (DRXR).

Q: What advice would you give investors now? Sit tight?

A: Sit tight? No, absolutely not. It's an incredible opportunity right now to look at your equity portfolio and to make sure you're diversified, so that you will have the opportunity to make the highest returns for the lowest amount of risk going forward. And that means being invested in large-cap, mid-cap, small-cap, and microcap opportunities, with some fixed-income and cash exposure.

The market isn't going to be like it was from 1996 to 2000. As an equity investor, we must get used to 6% to 10% returns per year, and we must also know and understand what we own, and why we own it. So I would not sit tight -- I would be actively looking to restructure my portfolio if I had already not done that.


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