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April 20, 1998
Analysts Scour Small-Cap Lists
Looking for Tomorrow's Giants
By SUZANNE MCGEE
Staff Reporter of THE WALL STREET JOURNAL
Figuring out which of the many tiny public companies has the potential
to become the Microsoft of tomorrow is the first, and greatest,
challenge faced by small-stock investors.
"It's ironic that to succeed as a small-cap investor, you need to figure
out what it takes for a company to become a big-cap stock, and then go
look for it," says Mary Farrell, senior investment strategist at
PaineWebber Inc. "It has become a lot harder, because small stocks have
had to fight harder for attention amid the big-stock mania, but those
great opportunities are still out there."
That's lucky, because there's a lot of cash looking for them.
Brian Stack, who manages about $2.62 billion in institutional and
mutual-fund assets for Massachusetts Financial Services, figures that he
has to sell as much as 25% of his portfolio each year after successful
stock picks metamorphose from small stocks into "mid-caps." That means
that he's constantly scouring the market for new companies in which he
can invest hundreds of millions of dollars.
"It's a research-intensive process," Mr. Stack says. "Figuring out the
potential size of the market is an art rather than a science. We try to
figure out how good the product is, and how big the market will be in
three years. We also try to figure out the product's potential to be
proprietary, and defensible."
For Mr. Stack, one of the best places to find tomorrow's giants is in
the technology-stock arena. The rapid pace of innovation in that
industry has been matched only by the rapid growth of companies with
cutting-edge products and niche markets, he notes. For instance,
Internet stocks like Yahoo! Inc., considered small stocks less than two
years ago, now command market multiples of 700 times earnings or more.
Yahoo's stock price has soared 514% in the past 12 months.
"This sector is a hotbed of innovation, and that means it has the
greatest promise for unit growth, revenue growth and earnings growth in
the economy today," Mr. Stack says.
Of course, for every Yahoo, there's a Comparator Systems, the Newport
Beach, Calif., fingerprint-identification company whose stock set
records for single-day volume as it soared from pennies a share to $2 a
share over a few days, only to collapse to trade at less than a penny a
share as regulators halted trading amid allegations that company
officials had inflated the value of the firm's assets. And for every
high-profile success or debacle, there are dozens more stocks that
simply fail to catch investors" eyes, or whose products fail to catch on
with customers.
To cut the risk, Mr. Stack has snapped up holdings in small companies
that benefit from technology applications in the workplace. While they
might not become giants like Intel or Microsoft, he believes they still
have the prospect to become heavyweights in their own, smaller markets.
Among these is Affiliated Computer Services, which integrates computer
systems and offers data-processing services.
"Rather than relying on the cycle of demand for one product, they have a
high level of recurring revenues from service contracts," he says.
"You're giving up some dramatic upside of a Yahoo, but also mitigating
the risks that your company will implode."
While many small-stock investors find that technology is the most
logical place to find a prospective giant, it's not the only place. For
instance, investors who like the idea of outsourcing could buy a
technology advisory stock like Affiliated Computer Services, or turn to
a more generalist company like On Assignment, which finds skilled
workers of all types for contract assignments.
"I'm really just looking for special businesses; a strong business
model, offering above-average profitability, with a return on equity
that's not cyclical in nature, where there's already revenue in place,
and where that revenue can grow at an average of 20% each year," says
Rick Leggott, chief executive officer of Arbor Capital Management, a
Minneapolis money-management firm he founded a year ago. "There are
zillions of little service companies that have come public in the last
few years that have been given opportunities to really thrive because of
the trend among large companies to outsource noncore functions."
Carlene Ziegler, co-founder of Artisan Partners, a Milwaukee
money-management firm, doesn't expect the stocks she buys to become the
next Microsoft. But she wants their product or service to have a
commanding presence in whatever market niche they choose to exploit.
"Looking for the next behemoth stock isn't the only way to invest in
small companies," she argues. "There are lots of companies out there
with great fundamentals and very good growth, that could themselves be
acquired by a big company, and shareholders will benefit that way."
Ms. Ziegler points to restaurant chain Showbiz Pizza Time as a case in
point. She says she doesn't expect it to become the next McDonald's, but
the stock has soared 71% over the past 12 months as its sales and market
presence have climbed. She owns stock in Littelfuse, the largest-single
supplier of the kind of fuses needed to manufacture any kind of
electronic equipment. Another example is a stock like Borg Warner
Security, which has a dominant position in the commercial
building-security business.
"This business is in the midst of a big consolidation wave," she says.
"Phone companies and utilities are looking at security as another
service they can package and deliver to homeowners. Since Borg Warner
has the most accounts under management in its business, it could become
a target."
Ms. Ziegler admits she would love to find the next Microsoft. But if she
did, that would present its own problems. For one thing, she wouldn't be
able to keep owning it for long: She automatically sells stocks in her
$300 million mutual fund when their market capitalization tops $1.5
million.
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