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Online Extra: The Small-Cap Growth "Minefield"


Growth investing, particularly in small-cap growth stocks, has traditionally been considered a high-risk strategy, yet in the past several years, it has also been rewarding. On an annualized basis, the S&P Small-Cap 600/BARRA Growth index has returned a healthy 14.7% over the past three years, beating other small-cap stock benchmarks as well as all mid- and large-cap groups, according to S&P's emerging growth analyst Markos Kaminis.

However, that could change in an inflationary environment. Kaminis warns that highly valued stocks are more sensitive to external factors such as pricing power. He recently spoke with BusinessWeek Online's June Kim on how to find the gems in the growth-investing area. Edited excerpts of their conversation follow.

Note: Markos Kaminis is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this article. All of the views expressed in this article accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: How have growth stocks been performing?

A: Over the past three years, the S&P Small-Cap 600/BARRA Growth index returned 14.17% on an annualized basis, outperforming the S&P Small-Cap 600/BARRA Value index and the S&P Small-Cap 600 index, which returned 13.13% and 13.8%, respectively. The S&P 500-stock index produced an average annual return of 4.64% on a three-year basis.

Year-to-date, small-cap growth stocks are still outperforming other small-cap groups but are falling behind mid-cap stocks.

Q: What's the outlook for the coming year?

A: I think growth stocks might be a bit of minefield, but you can still find leaders. In an inflationary environment, I'm more concerned about stocks that have a higher p-e and are sensitive to external factors.

Q: What about valuation?

A: Even though growth stocks have outperformed historically, they're not excessively valued. Looking at the p-e to growth ratio (PEG), including dividend yields, we find a yield-adjusted PEG of 1.09 for small-cap stocks growth, compared to 1.12 for small-cap value stocks. The smaller the number the better, and something closer to 1 is typically attractive. On this basis, they look more attractive than the value index.

Q: So what are you looking for in small-cap growth stocks?

A: If costs increase and companies don't have pricing power, they can lose market share. However, you try to find companies that are leaders within their markets and have pricing power within the small-cap growth sector. They're smaller companies, but they're important customers to their suppliers and have brand appeal to customers and a comparable advantage to competitors. They have the ability to raise prices and maintain market share and continue to perform well.

It's O.K. if they maintain a high p-e and look overvalued as long as they can maintain growth. Companies that have pricing power can maintain growth.

Q: What subindustries look attractive to you?

A: Health care is one, specifically veterinary health care because it's going to be less sensitive to price increases. A health-care name that we've rated a strong buy is VCA Antech (WOOF). It operates the largest network of veterinary diagnostic laboratories and free-standing full-service animal hospitals in the country.

It's also involved a large and fragmented industry where it competes against a lot of mom-and-pop shops and can differentiate itself as a premium supplier of pet care. As it grows it has economies of scale -- it can buy supplies in bulk at lower cost, advertise more easily and cost-effectively, and bring customers to multiple locations.

Q: Do you like any other growth stocks?

A: We have a buy rating on Martek Biosciences (MATK), another health-care name that won't be sensitive to inflationary concerns. It's a provider of food additive that's being incorporated into infant formula. Martek has been ramping up capacity and has gone through growing pains in the process of meeting demand. Most recently it disappointed when it announced its April quarter would be well below consensus expectations because of a shortage of an important component in its food additive -- one of their suppliers couldn't deliver the component. However, I see this slip as just a one-quarter event, and I lowered my target by only $3, to $72 from $75. On a long-term basis, I like the stock.

The company is providing itself with a second market besides the infant formula. It's also looking to penetrate the regular food market and has already signed a deal with Kellogg (K). We expect them to recognize revenue from the deal in 2006.

I also like musical instrument retailer Guitar Center (GTRC), a stock that has gotten cheaper recently. We have a strong buy o it. Similar to VCA Antech, Guitar Center competes in a fragmented market and benefits from economies of scale. Despite recently restated earnings guidance and concern about a potential shareholder lawsuit, over the long term, the story at Guitar Center remains good because long-term cash flow won't be affected. EDITED BY Edited by Patricia O'Connell


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