Market consensus these days favors large-cap stocks, in large part because the small guys have had their day in the sun. The foot soldiers have outmanuevered the generals in the battlefield -- much to the dismay of the big institutional managers who usually prefer the blue chips. And so, the argument goes, this year the big guys will finally have their day.
Wrong. Sure, there will be some big-caps that will win big for one reason or another. But the small stocks will continue to outscore the blue-chip averages, namely the Dow Jones industrial average, and the Standard & Poor's 500 stock index. True, the Dow and the S&P have been pushing higher in 2006. But so have the small-stock indexes -- in fact more so, specifically the Nasdaq composite index and the Russell 2000, both of which track low-to-mid cap stocks.
It doesn't look like the Nasdaq and the Russell, which are winning the race so far this year, will lose steam anytime soon. In the past 52 weeks through Feb. 21, 2006, the Nasdaq and Russell have clobbered the Dow and S&P: The Russell 2000 jumped 17.62% and the Nasdaq 11.46.%, outdistancing the Dow 's 4.31% and the S&P's 8.35%.
FAMILIAR GROUND. Enough market analysts have explained the myriad reasons why small stocks tend to outperform the biggies. One reason why the biggies aren't catching investors' imagination: Most of these giant corporations, such as Microsoft (MSFT), Exxon Mobil (XOM), General Electric (GE), and of late, Google (GOOG), are not only enormous in terms of market size, they are constantly under the microscope of analysts and investors.
"Discovering" something new and materially significant about them is nearly impossible. However, companies with market values of less than $1 billion are little known and neglected by the Street. Moreover, the honchos of the money-management world wouldn't dare touch them unless they get up to a certain market capitalization that provides so-called "liquidity," or enough shares outstanding that investors can get in and out of the stock whenever they wish. An easy escape route, if you will.
And, of course, those big investors don't know or trust these small companies. To know them would require diligent research -- and the time to do it. So there are market players who profit from all these little, under-the-radar stocks that spell RISK to the big investors.
INTRIGUING TRIO. Here are three undiscovered small-cap stocks that could produce home runs.
The first is Blair (BL), a 95-year-old company listed on the American Stock Exchange and currently trading at $40.75. With a market value of just $165 million, the big investors don't bother to look at this company. Blair sells fashion apparel for men and women and a range of home products by direct-mail catalogues. The company also operates some stores in Pennsylvania and Delaware.
Another little-known, undervalued stock to watch: Warwick Valley Telephone (WWVY), which trades on the Nasdaq. The stock was mentioned in my BusinessWeek Inside Wall Street column in the issue of Jan. 30, 2006, when it was trading at $17 a share (see BW Online, 01/30/06, "Will A Small Operator Hang Up Its Phones?"). It has since climbed to $21. But it is still below its real value, according to people close to it.
SWAMP FOX? Warwick Valley Telephone's phone operations in New York and New Jersey have been money losers, which has driven its stock down from $25 in July to $17, before rebounding to $21 after it was highlighted in my column. Warwick's biggest asset is its 7% stake in a company called Orange County Poughkeepsie Limited Partnership, which sells wireless minutes to bigger phone operators. This Orange County outfit is 85% owned by Verizon Communications (VZ).
Warwick's management could spin off its telephone business and just keep OCP. But of late, rumors have surfaced that Warwick might put itself on the block, mainly because of financial difficulties. True enough, on Jan. 31, it retained the services of investment bank Stifel Nicolaus & Co. to assess the company's options.
Another small-cap stock that could be a potential big winner: Biloxi Marsh Lands Corp. (BLMC), trading at $44.87 a share with a market value of $123 million. The company owns about 90,000 acres of marsh lands in Louisiana's St. Bernard Parish. Most of its income and revenues from oil and gas exploration and production activities on the property. It leases out part of the property to oil companies, mainly to Meridian Resources Corp. TMR
SMALL CAN BE BEAUTIFUL. Biloxi trades over-the-counter or so-called "pink sheets," and trading in such stocks isn't for the amateur investor. It takes experience and Street smarts to be able to mine the real gems in this arena. But pros who deal in these stocks contend that with diligent digging, enough information can be obtained on these companies.
Some information can be gathered from publicly available sources, such as Bloomberg. All publicly traded companies must issue reports to shareholders, including sales and earnings. All publicly traded companies are supposed to report material activities but those traded on the pink sheet usually take their sweet time in complying.
Although their numbers are few, some more adroit and resourceful big investors do dare to put their money in tiny companies. One pro in this universe of pint-sized stocks is Lawrence J. Goldstein, founder and general partner of hedge fund Santa Monica Partners, in Larchmont, N.Y. Mainly from investing in such stocks, Santa Monica since its inception 25 years ago posted gross returns of 5,840% and net gains of 2,305%. "I usually buy shares in companies that deserve a kick in the pants for management to take action in enhancing the value of their stock," says Goldstein.
RETURN ON INQUIRY. Santa Monica, which owns a 10% stake in Blair, believes it is takeover bait. It has receivables of some $180 million. Last year, Blair bought back shares 10% of its share outstanding, partly in response to pressure from stakeholders like Santa Monica. Rumors have swirled Of late that a suitor is stalking the company. Blair denied it has received any offers. The company posted earnings of $4.79 a share on sales of $456.6 million in 2005.
Warwick counts such big fish as Citigroup (C), Wachovia (WB), and ace private investor Michael Price among those who own the stock. Santa Monica Partners is also an investor.
When investing in small-caps, it's usually best if the company is an established one with real sales and earnings. Exceptions are biotechs or high-tech outfits, where lack of products is understandable and the promise of big returns can be great. In investing, the key is research, research, research.