Here's the article i told you about yesterday. Interesting
Everyone agrees that we are in the midst of one of the great
markets of the century, but I think we must be in a remarkably
smart market, too. It has to be smart to make so many
experienced investors look dumb.
To put it another way, I've never seen a rally in which there were
so few ways to make money. At the end of the second quarter,
with the Dow Jones already up 1,224 points for the year, I
asked Logical Information Machine, a Chicago company, to
figure out how many stocks, on all the major exchanges, had
fallen a third or more from their 1996 highs. The answer amazed
me: 485.
The problem is that since May 1996 a small and shrinking
number of companies have been attracting all the capital. These
are almost all very large companies. If you've bought
small-company stocks, even solid ones with fine products and
inspiring balance sheets, you've probably been wondering how
you missed all the fun.
They've certainly been wondering that at Corporate Express
(Nasdaq: CEXP), a small company that has become the world's
largest provider of office products to large corporations.
Corporate Express has been making acquisitions and has had
some earnings glitches. Like a lot of small, young companies, this
one has some warts. But it's well positioned in a growing
industry, and if it can get a handle on its problems, it might realize
its potential. That's what I think, at any rate, and I own shares.
I'm waiting for the market to agree with my assessment. It has
knocked Corporate Express from a 1996 high of $31 a share
down to about $14.
Several events have marked the "small-cap carnage."
The amazing thing, of course, is not that any one stock can be
roughed up like this but that the trouble can be so widespread.
Here are just a few ways of describing what I've come to call the
small-cap carnage:
Last year, the Standard & Poor's 500 Stock Index was up 20.3
percent. Remove the 25 largest companies, and the return falls to
12.2 percent. Remove the 50 largest, and the return falls to 9.1
percent. Take out the 100 largest companies, and the return
drops to 5.4 percent. You might as well have bought a
money-market fund rather than the 101st- through 500th-largest
companies in the premier large-company index.
The Nasdaq composite index rose 22.7 percent in 1996. But the
median return was only 6 percent. That means half the stocks in
the index didn't even return 6 percent. In a market that rose
almost four times that much, that's a pretty good working
definition of a narrow rally.
Through May this year, the Nasdaq was up 8.5 percent. Just
four stocks, however, accounted for more than two-thirds of that
gain--Microsoft, Intel, Dell Computer, and Applied Materials.
Take those four out, and the Nasdaq Composite Index would
have been up just 3.5 percent.
The Russell 2000, the most prominent small-company index, has
outperformed the S&P for only a few months since early 1994.
For the 12 months ended April 30, 1997, the Russell 2000
trailed the S&P by 25.1 percentage points--the largest gap since
the Russell 2000 was formed in 1979. Within the subsectors of
the 2000, there is another stupendous gap. In the second
quarter, the Russell 2000 Value index was up 20.6 percent while
its Growth index fell 5.4 percent. I think we've found the center
of the carnage.
Let's look at mutual funds. As recently as 1993, 66.1 percent of
all diversified equity funds beat the S&P 500, according to
Lipper Analytics. Last year, fewer than a quarter of 2,093
diversified funds beat the index. This year just 3.9 percent were
ahead as of June 30.
What the heck did the other 96.1 percent do wrong? They were
foolish enough to believe that there were more than a few
handfuls of good companies. Some were small-company funds
by charter, so they couldn't buy Microsoft, Procter &
Gamble, Coca-Cola, or Gillette. Others had the right
companies, but didn't own enough of them.
What was the cause behind the slump?
Clearly, there were a lot of factors in this debacle, and there's
plenty of debate over which is most important. Some people
point to the insatiable demand for index funds. Cash flowing into
index funds has risen from $39 million in 1988 to $18 billion in
1996, according to Morningstar. What's more, in the short term,
index buying is self-perpetuating. The S&P 500, by far the most
popular index among investors, is weighted by market cap--that
is, each dollar that comes into the index buys more of the largest
company in the index than it does of the next largest. The next
dollar buys even more of the largest company, and the next
dollar more again.
Other people point to valuations. By mid-1996, when the
performance gap between small and large companies appeared
and quickly widened, most stocks could be seen as relatively
expensive. The price-to-earnings ratio on the S&P was about
19. That was high enough to make people nervous. The p/e on
the Russell 2000 was 25.5. That was high enough to make
people sell. Investors began focusing on big, familiar companies
with consistent earnings. It has never been too hard to believe
that Coca-Cola will continue to make money, and investors
decided they'd rather pay a p/e of 30 for Coke than for some
brand-new networking company. Of course, this strategy has its
own problems. Now these folks have to figure out how they feel
about owning Coke at a p/e of 46--and at 26 times expected
earnings for the year 2000.
Then there's the ascendancy of momentum investing: Plenty of
investors are selling small stocks and buying large stocks simply
because the large stocks keep going up, for reasons they'll let
other people worry about. In the long run, I don't think that's a
formula for success. It's true that the giants attracting all this
momentum money have been putting up good and sometimes
great earnings, and in that sense it's probably unreasonable to
complain. But to justify their current valuations, these companies
need to produce consistently accelerating earnings. That's tough
for big companies. And if they don't find a way to do it, you
know the momentum investors will drop them like a bad habit.
I could go on. Small-company professionals do. They point out,
for example, that there were 790 initial public offerings last year,
nearly three per business day, and that this flood diluted the
limited capital available for risky new companies. (Of those 790,
by the way, 45 percent are now trading below their offering
prices, according to Securities Data. Did you get shut out of
something a year ago? It might be coming back around, cheaper
and a bit battle tested.)
What should be the next move for investors?
But this is all history. It's not nearly as important as figuring out
whether small-company stocks have hit bottom and what to do
from here.
Most small-company fund managers and analysts think we've
seen the worst of it. The month of May was very good for them,
and June was definitely not bad. I haven't heard anyone saying
there's nowhere to go from here but up, but I detect a humble
optimism.
I'm also encouraged by some analysis provided by the people at
T. Rowe Price's New Horizons Fund, a small-company growth
fund with 36 years' worth of experience to draw on. Take a look
at the chart on this page, which compares, on a relative basis, the
average p/e of the stocks in the New Horizons portfolio with the
p/e of the S&P. Historically, when the fund's p/e reaches twice
that of the S&P, the fund--a good proxy for that sector of the
market--is near a top. When the fund's p/e drops to the same
level as the S&P or just above, the fund and the sector are at a
bottom. At midyear, New Horizons's p/e had dropped below
1.2. Jack Laporte, who runs the fund, notes that falling prices
and rising earnings have knocked the average p/e on the stocks
in his portfolio from 26 or 27 to about 21. Considering that he
expects earnings on these stocks to grow 25 percent annually, he
has a right to feel good. One of my favorite rules of thumb is that
the number for the growth rate of earnings should be higher than
the p/e. That's a quick and meaningful way to look at a growth
stock.
I don't want to suggest that none of the companies that have
suffered in the small-company sell-off deserve their fates. To the
contrary: When a stock takes a bad fall, there's usually a reason,
though in times like these the damage is often out of proportion
to the problem. Our job as investors is to identify the problem
and evaluate it. Remember: Finding cheap companies is no more
useful than it is difficult. The profit is in finding cheap companies
that have turned or are ready to turn the corner.
Lynch checks in with analysts for their views.
To identify companies that might fall into this category, I spoke
with some well-respected growth-stock analysts and portfolio
managers and asked them about their favorite beaten-up stocks
with market capitalizations under $1 billion. They had more than
a few stories.
Mike DiCarlo, emerging-growth portfolio manager at DFS
Advisors, looks for small domestic companies with earnings and
revenue that are growing at 25 percent or better. DiCarlo likes
United Auto Group (NYSE: UAG), which sells new and used
cars and trucks through 52 franchises in 12 states. In February,
the stock was hurt by an earnings glitch, but DiCarlo expects the
company's earnings to rise 40 percent this year. The stock has
dropped from a high of about $35 a share to $21. DiCarlo also
likes Firearms Training Systems (Nasdaq: FATS), a Georgia
outfit that produces simulation training systems for the military,
law enforcement, and the sport of hunting. FATS also has 90
percent of its market. A potentially huge military contract is in the
works. The stock has dropped from a high of $16.25 and is now
selling for $13.50.
Bernard Picchi, head of emerging growth research at Lehman
Brothers, likes speech-technology company Lernout &
Hauspie (Nasdaq: LHSPF), which went public in December
1995 at $11 a share, soared to $53, and then collapsed to
$14.50. It now trades around $29. Picchi estimates the
company's earnings at 97 cents a share for this year and $1.65 a
share next year. He also likes Catalytica (Nasdaq: CTAL), a
manufacturing outsourcing company that develops catalysts and
systems to eliminate pollution. The company went public in 1993
at $7, and the stock price sailed to $14.625. Soon after, it
dropped to about $3. Now it's over $12. Picchi thinks
Catalytica will lose 40 cents a share this year but turn a profit of
45 cents next year.
Michael Moe, director of growth stocks at Montgomery
Securities, looks for premier companies in growth industries. He
likes Adtran (Nasdaq: ADTN), an electronic-equipment
company that produces high-speed digital-transmission
equipment for telecommunication companies. The stock traded
as high as $75 in July 1996 but soon fell with the rest of the small
companies and is now in the mid-$20s. Moe believes Adtran is
well positioned in an exploding industry and should grow at 30
percent a year. He also likes Lone Star Steakhouse &
Saloon (Nasdaq: STAR). The stock was a highflier for a few
years and then began to have problems with its same-store
sales--and then a drop in share price. It has fallen from a 1996
high of $45 to a 1997 low of $17.875. Still, Moe believes that
Lone Star has one of the top management groups in the
restaurant industry and that the stock will rebound.
Bill Nasgovitz, manager of the Heartland Small-Cap Contrarian
Fund, likes Lawyers Title (NYSE: LTI), the sixth-largest
title insurance company in the United States. Lawyers Title's
tangible book value--which for insurance companies is primarily
invested securities, often Treasurys--is $23 a share, while the
stock price is about $19.50. As Nasgovitz points out, this means
you get $23 worth of Treasurys for $19.50. Another insurer that
catches Nasgovitz's eye is MMI Companies (NYSE:
MMI), which sells medical-malpractice policies. The stock's fate
has been typical: Earnings were off in the first quarter, and
momentum players couldn't sell it fast enough. The stock now
sells for about $26--about ten times Nasgovitz's estimate of
1997 earnings.
Discretion is usually the better part of valor when it comes to
calling the market, and I do try to be discreet. So I'm not going
to tell you that I know when the change is coming. But I will say
that, when it does, I expect it to take one of three forms. The
least likely scenario is that we will have more of the same--huge
companies will continue to dominate. There is no historical basis
for believing that the gap that began to open up last May will
continue.
A somewhat more likely scenario, because you can never forget
that this kind of thing can happen, is that big-company stocks will
fall sharply and take the rest of the market with them. Believe
me, if a large-stock correction happens, small stocks will go
down, too.
The third and, I think, most likely possibility is that large
companies will go sideways for a while and small companies will
begin to close the gap.
Your research into small companies should serve you well
whatever develops. You aren't trying to call the bottom for the
small-cap market or for any company. You're looking for
companies that will consistently earn money, because they'll be
rewarded for it.
A final thought: Come this fall, your research might become even
more valuable. In the latter part of every year, investors sift
through their portfolios for losers, which they sell to offset their
gains at taxtime. Tax-related selling used to take place in
December; now it starts earlier each year. Given the recent
run-ups in the Dow and the S&P, you can expect that looking
for losses is going to be a national pastime by Labor Day.
Undervalued stocks will drop even further.
So be ready. Good opportunities do get better.
Peter Lynch is vice-chairman of Fidelity Management and
Research. His third book, Learn to Earn, written with John
Rothchild, was published last year by Simon & Schuster. He
writes "Investor's Edge" with Dan Ferrara. Research assistance
is provided by John Fried.
Company Index
Corporate Express, Inc.
Microsoft Corporation
The Procter & Gamble Company
The Coca-Cola Company
The Gillette Company
United Auto Group
Firearms Training Systems |
