Micros On The Brink
MICRO-CAP TRENDS
By George S. Mack ÿÿÿJuly 29, 1998
A 'Macro-Event' Could Make These Smallest Caps Take Off
Small stocks are currently cheaper and their earnings are higher than
their large counterparts.
The old axiom is: the smaller the stock, the higher the return. But if
that's the case, the bull market ought to present terrific returns on
micro-cap stocks - those with $250 million and under in market
capitalization. But not so fast. Things have been different this time
around, and there's frustration in the ranks of money managers and
analysts.
Strategist Daniel Coker of Schroder & Co.'s Emerging Growth Research
believes the current situation is unusual, to say the least. "Currently,
micro-cap stocks are cheaper than their larger counterparts even though
their earnings are much better," he says. Continued downward earnings
revisions in the big-cap S&P 500 stocks are expected, according to the
analyst, but that is not the case for small-cap earnings. Lamenting the
way investors have thrown money at the large stocks, Coker says,
"They've been willing to pay a very high price for liquidity, while
allowing the micro caps to bleed profusely." He illustrates his point by
saying that the S&P 500 is trading at about 19.5 times 1999 earnings,
while the smaller stock Russell 2000 index is trading at only 17 times
1999 earnings. "So we're seeing a significant discount in the smaller
stocks," he adds.
Poised To Outperform
By the end of the year, Coker believes, investors will have come around
to his way of thinking: Small- and micro-cap stocks offer value and are
poised for "a multi-year outperformance cycle." Even though small caps
have more risk in terms of liquidity and diversity, they're growing at
more than 30% while trading at 12 to 15 times earnings. An "expensive"
stock in the small- and micro-cap arena is trading at 20 times earnings,
"and that's in line with the S&P 500," Coker says.
Explaining what must occur for micro-cap stocks to finally gain
recognition and take off, Marcus Robins, editor in chief of The Red Chip
Review, says, "It's going to take a macro-event. It could be a large-cap
disappointment or perhaps the waning of big-stock performance in
general. It may be as simple as large caps pouncing on the small caps to
acquire incremental growth." The Red Chip Review focuses on previously
"unpublicized and undervalued small-cap stocks."
Depending on the particular industry, there's a good chance that smaller
stocks will decline less than large caps in a general downturn, says
Robins, because "small caps are not selling at the ungodly P/E ratios of
larger stocks." Echoing others, he says that small and micro caps have
been growing much faster with better earnings comparisons, and fewer
negative earnings comparisons, since the first quarter of 1997. "Yes,
there's better value," says Robins, but he's not convinced the market is
going to shift into small stocks wholeheartedly until there is some sort
of catalyst to make that happen.
Two things must become meaningful if there's to be a mass movement into
small companies, he says. "First, investors must come to the conclusion
that growth is a motivator of the economy, and second, that growth is a
determinant of value."
Looking For Innovation
Robert Kern has been in the micro-cap business for more than 30 years,
and today his firm, Kern Capital Management, is sub-advisor to the $170
million Fremont U.S. Micro-Cap Fund. He defines a micro-cap company as
ranking in the bottom 5% of the equity market with a minimum of $10
million. Today, he says, that works out to a $10 million to $440 million
capitalization - a far-reaching group encompassing more than 5,000
stocks at the end of the first quarter. "Our investment style is growth,
and we're focusing on those sectors where the level of innovation is
greatest," says Kern.
His method is fundamental - not only from the perspective of income
statements and balance sheets, but also in his approach to visiting
companies. Kern wants to see the facilities and discuss business
strategies with management. He's not interested in sectors that are
sensitive to macro-economic trends, like finance, which is dependent on
interest rates, or energy, which is tied to oil prices. "Our ability to
analyze a company on a fundamental basis is going to serve us better
when it's not tied to some macro-economic issue," he says.
Kern loves certain areas of technological innovation. He's particularly
interested in broadband communications. "The 56K modem is completely
obsolete in terms of what the newer technologies will bring, with speeds
that are 30 to 50 times as fast," he says. Kern is also investing in
certain new semiconductor production methods that allow manufacturers to
get multiple layers of circuits on silicon chips. "We make sure that we
organize and focus on the sectors with the best opportunities."
Portfolio manager Daren Heitman has a different approach. He manages the
Skyline Small Cap Contrarian Fund, which was started at the end of
December 1997. As the fund's name implies, Heitman is not looking for
companies with recent outstanding performance. As a "contrarian," he's
looking for turnaround stories. "The most opportune time for us to buy a
company is when it's not doing well fundamentally - that is, when
earnings are depressed," he explains.
Heitman looks for small companies that are having "short-term problems"
and snaps them up while they're out of favor. After finding a company
that's fallen on hard times, he makes sure it is cheap on an absolute
basis. "I'm looking for all the low multiples - price to sales, earnings
and book - for all low values," he says. Right now, his portfolio has a
median price-to-book value of only 1.3, which is low by any standard.
Currently, there are many stocks in his portfolio trading below book
value.
Safety Versus Value
Claudia Mott, director of small- and mid-cap research at Prudential
Securities, believes the market has become more volatile, owing to
rising concerns over the future rate of earnings growth. Moreover, she
echoes what she has heard from the buy-side community: the fear of the
impact that non-U.S. economies, especially Asia, may have on small
stocks. "Unfortunately for the small- and micro-cap segments, these
concerns have caused people to shun that part of the marketplace," she
says.
Mott, a quantitative analyst, says the very small stocks have a lot of
good things going for them, especially a favorable interest rate
environment, along with terrific earnings growth and excellent
valuations. However, the focus remains on the large liquid names.
"Investors want to be in big, liquid, tradable, safe names, and micro
caps just don't fit those criteria," she says.
Market Scenarios
"It may take a large-cap sell-off to shift investors' focus to the mid-,
small- and micro-cap companies as more attractive places to invest,"
says Mott. "However, you're not going to have a major pullback without
the small- and micro-cap stocks participating in it, as well. That just
doesn't happen."
She describes one possible way for the situation to play out: First, the
market corrects, and then the large caps rebound as the leaders.
However, with so many of the big caps still selling at extreme
valuations, they would be unable to carry the momentum. Then the
smaller-cap segments take the market farther beyond that initial
bounce-back period. "That's one case some people are trying to build,"
Mott says.
"It's kind of weird, if you go back and look at the late 1970s period,
when the small stocks performed extremely well," she says. "You might
almost say that rising interest rates and inflation are not a negative
for the small-stock sector. But the way I prefer to analyze what
happened is that coming out of the 1973 to 1974 recession, there was a
really dramatic pickup in economic growth that was helping those small
companies, not the high rates."
Mott says investing in the small-cap equity market requires a long-term
perspective. Everybody knows the "performance advantage" of small-, mid-
and micro-cap companies, and usually the progressively smaller they get,
the better the performance has been. However, "I think what we tend to
lose sight of is that all of those returns are based on very long buy
and hold calculations," she cautions. "Even missing a day here and there
or one good month can drastically alter those performance numbers on
which someone has based their expectations."
At some point, Mott believes, small and micro caps are going to be
leaders again. However, investors have to be in position because it
could happen very quickly. "To shift an allocation or to get fully
invested may not be that easy," she warns.
Shifting Assets
Whose fault is it that the small sector hasn't performed? "It's the baby
boomers," Mott says with a laugh. It's been a shift from defined benefit
to defined contribution plans, like 401(k)s. Those assets are invested
"very differently" than they used to be. In addition, a much larger
segment of the population is participating, and when the choice is a 3%
savings account versus a 30% per year return in the S&P 500, "what's the
choice going to be?" she asks.
Mott says insurance and specialty finance are ranking very high on her
small-stock quantitative model, but regional banks look overvalued. In
the technology area, she likes both computer software and services, but
her numbers say that the hardware side is expensive and does not have a
lot of earnings momentum. She also likes some economically sensitive
groups, such as homebuilding, auto parts, steel and even some
manufacturing areas.
Private money manager K.C. Grainger handles accounts for individuals and
institutions. He says there are about 2,000 stocks that get the bulk of
Wall Street coverage, with anywhere from five to 40 analysts following
them. Then there are another 2,000 to 3,000 smaller companies that get
only one or two analysts. That leaves about 5,000 much smaller companies
that get nothing. "These are the ones that I look for," he says. "You
can find some very undervalued situations in that group. I'll even look
at a stock with a $4 million to $10 million capitalization."
Doing the tough homework, Grainger calls, visits, and studies insider
trades at each company. "It's important when you see a group of officers
and directors buying. That says something." He also indicates that
patience is important. He's willing to sit on limit orders for long
periods. His universe of stocks is such that he must limit the number of
shares he buys. "I don't want to be the whole market in some of these
small stocks."
Always a value player, Grainger uses charts and buys stocks near their
lows. "When small and micro caps fall, they do so with a vengeance, and
there's generally no support," he says. "I always want to be much closer
to the low." Finally, when a stock moves up, "I always sell into the
move and take some money off the table," he adds.
Keith Mullins, emerging growth analyst at Salomon Smith Barney, is head
of his firm's small- and mid-cap strategy group. He agrees that the
markets in general are somewhat confused by the favorable interest rate
environment and deteriorating earnings in big index stocks. There's also
irony in that the Asian destabilization is one of the factors
frightening investors away from smaller stocks. In fact, he says, the
large multinational companies' earnings will suffer the most from Asian
economic turmoil.
Risk May Be Contagious
"Nevertheless, the big risk is that there may be further destabilization
in the Far East, which can become contagious on a global level,
affecting our markets, as well as the European markets," says Mullins.
"It's going to take years for the Asian markets to re-adjust to slower
economic conditions and the bad decisions made over there." To that
extent, he believes the U.S. equity market offers security. The bond
market, in particular, is "very attractive on a global basis, given our
inflationary environment," he says.
What will happen in the future is not certain, but from a historical
point of view, some very attractive values have been created.
"Valuations in micro caps are very good," says Mullins. "I believe that
since there is less earnings growth available in the larger-cap stocks,
you'll find capital migrating down the scale and ultimately reaching the
micro caps." That process, he says, could be as quick as it occurred in
the second and third quarters of 1997.
Waiting Period
"My sense now is that on a short-term basis, as we wait out this period
associated with Asia, the small caps are not going anywhere," adds
Mullins. "But if you give it six months to a year, the smaller-cap names
will do well because the markets will begin to appreciate the value and
the earnings growth, and the lack of it in the large caps."
Mullins warns that if the large-cap stocks were to "violently correct"
on the new lower earnings expectations, it would be very troublesome to
the smaller names. However, he believes if it's more of a normal,
organized consolidation, or even a pullback, there's ample historical
evidence that the smaller stocks can do well in that environment. "I
would really suggest investing for a year out. It saves you from getting
'hyper' about the short term," he says.
Speaking of the propensity for micro caps to correct deeply, Mullins
notes that "any stock that gives you the opportunity for a double or
triple is also going to offer the same amount of risk on the downside."
As a result, he maintains a very strict sell discipline, and his first
rule of thumb is, if a disappointment is a reflection of intensified
competition, which would be evident when gross margins are contracting,
then you unload the stock. "Selling in this situation is almost
essential," he says. "Investors can't just sit around and hope the
company will win on a competitive front." His other rule is that if
there's a saturation concern or if the product is becoming obsolete,
then he again advises institutions and individuals to sell. "It's very
difficult for a company to reinvent itself or expand markets in this
situation."
For micro caps, Joseph Garner, director of research at Emerald Research,
says the theme is to dominate a niche. It is important to find a number
one or number two in a given market, he says. "If you find an 'also-ran'
that's competing with the likes of an Intel, a Compaq or a Microsoft,
then you don't want it. It would have no pricing power, and terms are
often dictated to the small company."
Garner says that although you expect to see higher earnings growth in
smaller stocks, you should also expect much higher volatility in their
growth rates. It's not out of the realm of the norm, he believes, to see
earnings grow in excess of 50% and then have that growth curtailed
rather quickly. "Because they are micro caps, they tend to be vulnerable
to changes in the marketplace - they tend to be closely tied to
individual market segments," says Garner. "When the fundamentals in
those segments deteriorate, the impact tends to be dramatic - sharp and
quick."
On the plus side, he says investors have an opportunity because they can
more readily find the undiscovered gems. "We want to take advantage of
the inefficiencies in that marketplace," says Stacey Stichter, an
analyst at Emerald Research. In her position, she works to shed light on
stocks that have been underfollowed. "By increasing the information
flow, you increase the efficiency."
Impact Of Management
Both Garner and Stichter agree that evaluating a company's management
team is crucial in micro-cap investing. Though not normally the case in
a large-cap company, "a small group of people can have a dramatic impact
on the success or failure of a micro-cap company," adds Garner.
Stichter continues, "We're not there just to analyze the numbers, we've
got to be a character judge in a lot of instances." Indeed, many of
these tiny firms don't have a lot of track record, and the investor has
to put a lot of faith in management's ability to grow the business.
"That's why we like to get out to see them," she says. "We want to meet
the employees and top management people right in their own element."
Stichter also visits both the manufacturing and distribution facilities,
as well as suppliers. "The more people you get to talk to, the better
the insight you have on the company."
Garner agrees, "When companies come to see us, they can put a spit-shine
on themselves and the company. But when we go to their sites and see
them on their own turf, we can get a much more accurate picture of the
companies as they really are."
Carl Wilk, portfolio manager of the Munder Micro-Cap Equity Fund,
believes the general marketplace of large stock is "overvalued - anyway
you slice it. Money tends to follow the leaders. With big market deals
and acquisitions, it's the easiest place to go for liquidity."
Wilk describes himself as a stock picker and his fund group as a "GARP"
firm - growth at a reasonable price. His fund is currently underweighted
in technology issues, and he says his team has been looking for
"selective beaten-down stocks" to add to the portfolio. "The whole tech
sector looks a lot more attractive than it did a while back," he adds.
Joe Frohna, portfolio manager for the Firstar MicroCap Fund, says what
happened in May reminds him of what happened last October and November
when the Asian scare upset the markets. "There was a flight to quality -
there was no interest in owning small- and micro-cap stocks," he says.
"Add to that the uneasiness surrounding the nuclear situation in
Pakistan and India, and those events don't bode well for small stocks."
Getting What They 'Deserve'
Frohna echoes the sentiments of many others in the investment community.
"Basically, we're going to see a big-cap earnings recession, which will
be the ultimate driver that will encourage people to look at the smaller
stocks," he says. "Ultimately, this kind of event could give small
stocks the valuations they deserve."
He sees value in micro caps, noting that they are extraordinarily cheap
at this point. At the end of May, the small stock Russell 2000 P/E to
growth rate ratio was .63 versus the S&P 500, with its ratio of 3.1.
Frohna says the S&P 500 is growing "arguably" at 7%, which he believes
is on the high side. "I think people will have to revise their S&P 500
earnings estimates before it's all said and done." And as the large caps
begin to suffer, he says, they will make moves to acquire growth. "The
big companies will go out and buy smaller companies to fuel their future
expansion, and great value is going to be realized in small stocks."
But Frohna doesn't expect investors to switch over to small stocks
immediately. "The markets won't be rational," he says. "If Motorola is
having a bad quarter, investors won't jump wholesale into micro-cap
stocks. These things do take time - no question about it."
On a relative basis, small-cap stocks should begin to outperform over
the next year, says Frohna. "There should be a few years of good
relative performance for small- and micro-cap stocks - just like 1991
through 1993 when some of the best years in small-cap performance were
seen." Citing quantitative research from Prudential Securities, he notes
that back in 1990 - before the great performance for small- and
micro-cap stocks - the P/E to growth rate of small stocks was .67, about
6% greater than today's .63 figure. "Today's micro-cap market is very
compelling," he says.
Owing to the strength of the domestic economy, Frohna's fund is
overweighted in service and consumer cyclical stock |
