The following is an update on: (1) The ongoing market shift to value and
small cap stocks; (2) Increasing investor interest in the biotech sector; (3)
A commentary on how the Internet is shifting control to the individual; (4)
An overview of new Model Portfolio selections AremisSoft and SEMX
Corporation; and (5) Interesting investment articles on the Internet.
*******
SHIFT TO VALUE, SMALL CAPITALIZATION STOCKS UNDERWAY?
The Russell 2000 index of small-company stocks had its worst year ever in
1998 against the Standard & Poor's 500 index, with the small company index
lagging 31% behind the S&P 500 average. This in an incredible gap. The
performance was so bad that Business Week in August noted that
"small-company stocks endured their worst three-year performance relative to
large stocks in more than a generation."
Small Caps Have Worst Performance in a Generation
Other small cap indexes tell a similar story. The T. Rowe Price New Horizon
price-earnings ratio, long used barometer for small company valuations, fell
to its lowest level in 38 years this spring compared to the price-earnings
level of the Standard & Poor's 500. Small cap price-earning ratios were only
0.78 of those of the S&P 500. Historically the New Horizon to S&P 500 ratio
has averaged around 1.50. Small stocks have recovered somewhat since - but
the ratio is still hovers around 0.80.
The two other times the New Horizon relative price-earnings ratio fell below
one - it hit 0.95 in March 1977 and again in September 1990 - small stocks
strongly outperformed for several years thereafter. This spring's reading
fell well below these levels, which may bode well for this sector if history
is any guide.
Data from U.S. Bancorp Piper Jaffray also illustrates how undervalued many of
these small firms are: around half of the small cap firms that have gone
public over the last decade sell for less than one-half of the initial
offering price. These valuations so understate the underlying value of these
enterprises that a number of companies are going private. Forty-eight
companies went private in the last year, versus only 12 three years ago.
Experts See Opportunities In Sector
This discrepancy in small cap performance and valuation is beginning to
correct itself. John Bollinger, President of EquityTrader.com, recently noted
that his research indicated two significant events are occurring in the
market. The first is the shift of investor focus from growth to value based
stocks. The second is the shift of money from larger companies more into the
smaller capitalization firms. He expects that these trends will continue for
some time. Our interview with John where he discusses these trends is
available on Real Audio at:
audioinvestor.com
Matt Stichnoth, Editor of the Wall Street Companion, notes that the valuation
differences between small and large cap stocks have never been so extreme. He
expects the small cap rally to present many opportunities. As a value based
investor, Stichnoth says value is now found in small caps - and people will
wonder why they did not see this opportunity as a "once in a generation"
occurrence. Our interview with Matt is on Real Audio at
audioinvestor.com
Bill McVail, manager of the Turner Small Cap Growth Fund, sees several
catalysts that may improve small cap performance over the next six months,
including increasing demand from institutions for stocks in this sector. Our
interview with Bill - and his outlook on the small cap sector - is available
on Real Audio at audioinvestor.com
While some institutional investors scoff at small-caps - possibly because it
is very difficult if not impossible for them to participate in the sector due
to the amount of money they manage - this can be a profitable sector for
investors over the longer term. From a longer-term perspective an individual
who invested $100 in the Russell 2000 small company index at the end of 1974
would have a portfolio worth $6,300 now, while an investor in the S&P 500
over the same period would have a portfolio worth $4,800.
Small Company Mergers & Acquisitions Increase
Almost 800 small companies were acquired in either mergers or buyouts in
1998, up from around 450 two years earlier according to Charles Rinaldi,
manager of the Strong Small Cap Value Fund. And this M&A trend is
accelerating. Joe Frohna, manager of the Firstar Microcap Institutional Fund,
notes that in the early 1990's there were only around 160 mergers or
acquisitions of small companies each year, but we have already surpassed that
figure in 1999 - and mergers are continuing "at a blistering pace."
Others also see a strong M&A environment for small caps in 1999. Merrill
Lynch predicts that the number of small-cap mergers and acquisitions this
year will be the highest in a decade. Most notable is the surge in leveraged
buyout activity in which an investor group acquires a company and uses its
cash flow or asset sales to repay the purchase price. Merrill estimates there
will be as many small cap leveraged buyouts in 1999 as in the previous four
years combined.
Acquisitions Accretive to Large Company Earnings
Large companies are able to offer premiums to acquire smaller firms due to
the generous valuations assigned by the market to the shares of these large
firms. This degree of price discrepancy occurs very infrequently, and larger
companies can actually pay a premium and acquire companies that will
immediately be accretive to the larger company's earnings. In a sense, the
larger companies are using fully valued stock to purchase shares of entities
that are undervalued under the well tested theories of Graham and Dodd and
the like.
In fact, the current activity amounts to a "Graham and Dodd behavior that we
haven't seen in the market" for some time, according to Merrill's Satya
Pradhuman, director of small cap research.
Mergers & Acquisitions in the Lone Star Portfolio
The merger and acquisition trend has not bypassed the Lone Star portfolio.
Three of thirteen companies have been acquired or taken private the last year
or so, including Pharmerica and Laboratory Specialists.
The most recent to be impacted is Smartflex Systems (NASDAQ: SFLX), which
agreed to be bought by closely held Saturn Electronics & Engineering Inc.
for $10.50. We valued the company higher as an ongoing enterprise, however
under the business judgment rule the company has agreed to be sold to this
privately held Michigan based entity.
******
BIOTECH SECTOR RECOVERY WITH NEW DRUG APPROVALS?
Marking the end of a long drought for biotechnology stocks the Amex biotech
stock index recently surged to a record high, topping the old peak reached in
1992. The 1992 high was reached amid wild speculation about biotech's future,
much like those in the Internet sector now.
But many biotech companies collapsed in the early 1990s as the "burn rate"
quickly ran through the pile of cash many of these firms had accumulated. As
a result, biotech shares were driven sharply lower.
The index's rally this year mainly reflects the rising fortunes of the
largest companies in the biotech sector. Most of the resurgence in the index
is from the likes of Amgen and Biogen, and the enthusiasm has not carried
over to the hundreds of mid- and small-cap firms.
In a recent interview Michael Murphy of the California Technology Letter
noted that even though the biotech area has been through an 8 year bear
market he sees a light at the end of the tunnel. Today there are about 80
biotech drugs available in the U.S. But there are hundreds of drugs that are
at various stages of clinical trials. As they move closer to regulatory
approval, the companies look more attractive to investors and potential
pharmaceutical company partners.
Murphy notes that there were 13 biotech drug approvals in 1996, 27 in 1997,
52 in 1998 and there should be around 80 this year. Our interview with
Michael on the biotech sector and companies he likes is available for replay
on Real Audio at audioinvestor.com
Matt Berry of the Medical Technology Stock Letter also notes that the larger
biotech stocks have led the rally in the sector so far this year, but he
expects this strength to filter down to lower tier and smaller size
companies. Wall Street has finally discovered how undervalued this sector is
according to Matt. Merger and acquisition activity should be particularly
intense in this sector as larger pharmaceutical companies seek to add to
their drug pipelines - which they can now do at reasonable valuations.
Our interview with Matt (conducted Monday) is available on Real Audio at
audioinvestor.com - he discusses companies
he thinks are attractive including Chiron, ImClone Systems, Isis, ICOS,
Ligand, Cor Therapeutics, and others.
Lone Star Selection: BioSource International
Model Portfolio selection BioSource International (NASDAQ: BIOI $5) is
engaged in the development and marketing of products used in biotech and
biomedical research. It recently announced second quarter earnings of $0.13
per share, and $0.23 per share for the first six months. The company is
profitable, in the growing biotech sector, and undervalued.
BIOI's increase in sales and earnings was due to internal growth driven by
strong sales of assay kits, antibodies and proteins and as a result of recent
acquisitions. Based on the estimate of this years earnings the company sells
at a price-earnings ratio of 10, a price-to-book ratio of 1.9, and is
undervalued with a microcapitalization of $35 million.
******
INTERNET SHIFTING CONTROL TO INDIVIDUALS
The Internet is shifting control and power from the public to the private
sector - and to the individual - affecting everything from commerce to
representative democracy according to Andrew Shapiro, director of the Aspen
Institute Internet Policy Project.
In his new book "The Control Revolution" Shapiro argues that the Internet is
not just a shift in the way we communicate - it constitutes a radical shift
of who is in control of our lives. The individual now is in control of
information, expertise, and resources previously vested in big government and
big business.
The Internet Makes Physical Communities Obsolete
To an unprecedented degree individuals now choose what news and entertainment
they are exposed to, and the Internet has even allowed us to choose our
social contacts - which in most cases are located far from the physical
community where the individual lives. This is not all good according to
Shapiro, as the physical sense of belonging that one feels in a community may
be less evident in the Internet age, leaving behind many who do not
participate in the digital advances in communication.
While many claim that the Internet has limitless potential to improve the
life of the individual worldwide - as well as create untold wealth for
investors of successful companies - Shapiro notes some disturbing problems
that will also be created by this new medium.
Media Filters Still Play a Role
Information screens are available to individuals who can select what
information is delivered to them, removing them from participation in the
physical community. This tends to inadvertently remove the right of free
speech inherent in a democracy, essentially silencing those who may currently
have a voice in our democratic process according to Shapiro.
Further, our political system presumes that decision makers will make
judgments based on reasoned debate and deliberation, and that such decisions
are made by trained professionals acting as leaders. The Internet may change
these relationships according to Shapiro, probably for the worst, by altering
the democratic nature of our political system and taking power from our
leaders who may make politically unpopular decisions that are good for
society as a whole.
Internet access allows parties to sidestep the traditional big media
information "filters." Shapiro argues that these filters can be useful in
some situations. But by its nature, the current Internet media atmosphere
requires the instantaneous delivery of information like the "Drudge Report" -
which has caused stories to be published with numerous inaccurate facts,
misleading stories, and outright distortions.
For example, an employee of a technology company allegedly issued a false
press release that the company he worked for was going to be acquired by a
competitor - quickly increasing the stock price and the value of his 401(k).
The release had no basis in fact.
The Concentration of Information in New Hands
The Internet also tends to concentrate the power of information delivery into
a few major providers that get a majority of traffic - like Yahoo or AOL. So
the democratization of information on the Internet may not be what it seems -
it just concentrates information in new hands.
The Internet also allows individuals to avoid taxes - the lifeblood of local
governmental revenue streams for services. This can cripple services provided
by local governments.
The Role of Journalists
Shapiro argues that society needs to forge a compromise between new personal
liberties provided by the Internet and commercial obligations. He argues that
governments will have a smaller role to play, but individuals will also have
a responsibility not to disengage from the problems of the community.
The chief obstacle to this shift of power will be the desire of
institutions, governments and business not to lose control of the environment
they operate in. This can be seen in the recent lawsuits over messages posted
on Internet bulletin boards, where companies pursue claims that historically
would have been ignored if published in traditional media outlets.
Shapiro's solution is to increase the influence of middlemen, or of trusted
people to filter the flow of information - which should make editors and
journalists more valuable in the future, not less so.
Inefficiencies Reduced
While Shapiro makes some excellent points about the threat of the Internet to
the local community and political process, and the dangers of passing control
to individuals without the oversight of big government (witness the power of
day traders to win or lose big), his solution is not entirely without
problems.
The Internet is eliminating many commercial and governmental inefficiencies
that hinder commerce - which increases economic activity. There are no
geographic borders in the Internet age.
Overall "The Control Revolution" is worth reading, and Shapiro makes many
excellent points about how the Internet and electronic revolution may change
society, social, and business relationships.
******
NEW LONE STAR MODEL PORTFOLIO SELECTIONS
The following two companies have been added to our Lone Star Model Portfolio:
SEMX Corporation (NASDAQ: SEMX - $5)
SEMX Corporation (SEMX) manufactures and markets specialty materials and
services to the microelectronic and semiconductor industries. SEMX products
are used to conduct electrical currents, to solder or mount electronic
circuitry, to house the electronic components, and to dissipate internally
generated heat.
Ongoing increases in microprocessor speeds and frequencies, smaller designs,
and other advances in chip technology can create excessive heat - and
integrated circuits operate efficiently only in a narrow temperature band.
Excessive heat harms system performance and reliability.
In general, the smaller the device or semiconductor size the more problems
the designer has with regard to heat dissipation - and the more danger that
heat will impact reliability of the device.
As the industry moves beyond 300mhz capabilities the heat generated by the
microprocessor chip cannot be effectively removed by the traditional
copper-tungsten lids, bases, fin fans, etc.
Chip integrity is difficult to maintain at these frequencies as the heated
parts expand at different rates causing stress, cracking, and reduced
performance. SEMX produces metal alloys that can be used to help solve these
problems for 300+mhz chips.
SEMX's heat dissipation products are used to conduct heat away from critical
areas of electronic circuits where it can be dissipated. Heat dissipation
products are primarily used to conduct heat in high power wireless
communication devices and high speed microprocessor packages.
The company also supplies materials to the wireless communications segment of
the industry, making flanges for base stations and other products and
materials to support high bandwidth applications. As the telecom industry
utilizes different frequencies to transmit data more efficiently, new
materials and designs will be necessary to maximize telecom system
performance.
SEMX has three operating units, but the American Silicon Products unit is
expected to be sold in the near future leaving two operating units - one
focusing on brazing, solder, precision metal stamping and the like - and the
Polese unit which supplies engineered materials to the microprocessor and
electronic industry.
Clients of the Polese unit include Sun Microsystems, IBM, HP, and Texas
Instruments, among others, and sales from this unit are expected to post
healthy increases. The increase in demand for products from the Polese unit
will be met by an expansion of existing capacity, and the backlog of unfilled
orders bodes well for the short term future, if not longer term.
From loses a year ago, the company recently reported earnings of $0.16 a
share last quarter and expects to pay off all outstanding debt with the sale
of the American Silicon Products unit. Management feels that this company is
in the last stages of a turnaround after several years of disappointing
earnings and losses. No analysts cover the company.
The company is selling at a price-to-book ratio of 1.0 (versus a
price-to-book ratio of over seven for the S&P 500), has a debt/equity ratio
of 0.4, and based on estimated earnings for this fiscal year is selling at a
price-earnings ratio of 12.
Lone Star's Doug Fant interviews Frank Polese, Vice Chairman of SEMX (Real
Audio) at audioinvestor.com
***
AremisSoft Corporation (NASDAQ: AREM - $7)
AremisSoft Corporation develops, markets and supports applications software
targeted at the healthcare, manufacturing, hospitality and construction
industries. AREM's software products address the management of critical
information in various corporate sectors such as accounting, purchasing,
manufacturing, customer service and sales and marketing.
In the past five years AREM has experienced rapid growth both internally and
through acquisitions, with revenues increasing from $2.7 million in 1993 to
$42.4 million in 1997. During this period AREM successfully acquired and
integrated the operations of eleven businesses. The company currently has
more than 5,000 customers.
AREM went public in May, and sells its software in seven countries with
around 70% of revenues coming from the U.K. Around one-third of that revenue
is from the manufacturing sector. The price to sales ratio is 1.8, the
trailing price-earnings ratio is 12, and the estimated price-earnings ratio
for 1999 is 10. The company is a small cap firm with a market capitalization
around $90 million.
For the second quarter AREM revenues increased 36.0% from year earlier
levels. Net income for the quarter increased to $ 0.20 per share, and
earnings per share for the first six months increased 55.6% to $ 0.28.
The company has developed a niche in selling Enterprise Resource Planning
(ERP) software to middle size companies. Many companies in the ERP sector are
temporarily depressed due to Y2K fears, however longer term this sector
should do very well. Michael Murphy of the California Technology Letter also
likes the growth characteristics and valuations of companies in the ERP
sector. Our Real Audio interview with Michael where he discusses the ERP
sector is at: audioinvestor.com
AREM also has software products in the On-line Analytical Processing area
(OLAP) - another sector where demand is growing strongly. Some estimate that
demand for OLAP products will increase from $2 billion in 1998 to over $4
billion in 2001 - presenting opportunities for companies like AREM. Our Real
Audio interview with Richard Creeth, President of Business Intelligence, on
the projected growth of the OLAP market is at:
audioinvestor.com
The July, 1999, issue of Manufacturing Systems Magazine recognized AREM as
one of the Top 100 vendors of software for manufacturing enterprises, ranking
it No. 89 in the list of worldwide companies.
******
INVESTMENT ARTICLES ON THE INTERNET
Our "Interesting investment articles on the Internet" can be found at Mark
Johnson's Internet Financial Connection forum on the Silicon Investor at
techstocks.com
******
PERSONAL NOTE. We recently formed LSGI Advisors Inc. to manage the
small/microcap LSGI Technology Venture Fund L.P. We also assumed managerial
and editorial control of AudioInvestor.Com, Inc. We apologize for the delay
since the last Lone Star update - future issues will be more regular. Note
that LSGI may own positions in the companies we mention, but we remain in
spirit an investment club.
******
The Lone Star update is a non-profit publication that examines investment
issues and strategy. It is a closed, confidential, moderated mailing sent
only to those individuals requesting to be placed on the list. Should you
want your address removed (or added) to our list please let us know.
******
Joe Dancy, Adjunct Professor, SMU School of Law, Editor - Dallas, Texas
Doug Fant, Mobil Oil Corp., Contributing Editor
Mark Johnson, Internet Financial Connection on the Silicon Investor,
Contributing Editor
Lone Star Growth Investor
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