Heard on the Street Internet Gives a Lift To Small-Cap Issues
By ROBERT MCGOUGH
Staff Reporter of THE WALL STREET JOURNAL
To everyone who yelps that it is impossible to make a killing in
small-company stocks, don't be so sure. There has been an easy way to
make double-digit gains in small-caps this year.
All you had to do was buy the stocks of companies that are expected to
lose money.
So says a study by Howard Penney, small-cap strategist at Morgan
Stanley Dean Witter, who sliced and diced the returns from the stocks in
the Russell 2000 index of small companies. (Small stocks are generally
defined as those with stock-market value below $1.5 billion.)
This year through Friday, Mr. Penney says, you
would have made a nifty 24.2% return if you
had bought only stocks of the 190 companies in
the index that are expected to lose money or, at
best, earn no profit for 1999. That's a pretty
penny -- more than twice the 10.4% gain of the
Standard & Poor's 500-stock index of
blue-chip stocks over the same time frame.
What, however, if you had been so foolish as to
buy the 1,494 Russell stocks that are expected
to earn a profit this year? Bad move. You would
have lost 1.1% on that portfolio. (Mr. Penney ignored another 199 stocks
whose earnings projections weren't known.)
All of which shows what a strange trip it has been this year on Wall Street.
Why the big performance gap? The Internet, of course.
Even after last week's roller coaster in the sector, Internet stocks have
soared this year. Because so many Internet companies aren't yet earning a
profit, the overall performance of money-losing companies in the Russell
2000 has been superb. Indeed, one reason the overall return of the Russell
2000 pushed into positive territory for 1999 in recent days is due to its
Internet stocks; some of those stocks have grown into big-caps quickly
and will likely be taken out of the Russell index when it is adjusted in June.
The great performance by money-losing stocks this year is "one of those
aberrations that should stand out as an artifact" of 1999 on Wall Street,
says Jay Tracey, a small-cap mutual-fund manager at OppenheimerFunds.
"I think it will be something that we look back on" with amazement in the
future.
The future can't come soon enough for some small-cap and mid-cap
money managers. Their non-Internet companies are firing on all cylinders
-- but those stock prices are stuck in neutral. John W. Rogers Jr., manager
of the $197 million Ariel Fund, says his favorite stock, Specialty
Equipment, is doing a booming business selling equipment to McDonald's
restaurants, has beaten earnings expectations and been buying back stock.
The investor response? "No one cares," Mr. Rogers says. So the stock
has lagged well behind the S&P 500 index. "It's extraordinarily frustrating."
Gloria Santella, manager of the $600 million Stein Roe Capital
Opportunities Fund, points to Papa John's International, a pizza-delivery
company, as a "quite remarkable" company the market has ignored. She
cites 20 quarters of greater than 20% year-over-year growth.
"Five years!" Ms. Santella exclaims, "To me that's incredible." But while
the company is still growing strongly, the stock is down more than 8% this
year.
The problem, these managers and Mr. Penney
agree, is that investors have become
hyperfocused on the Web. Internet stocks
have drawn "money and mindshare" away
from other small-company and midsize stocks,
Mr. Penney says, even those whose earnings
are growing at what typically would be considered an excellent rate.
SportsLine USA, for instance, an Internet sports-information company, is
expected by analysts to post a loss of $1.92 a share this year, according to
First Call. And yet the stock had gained about 170% for the year through
Monday. Better yet: DoubleClick, an Internet advertising and marketing
concern, is expected to have a loss of 43 cents per share this year, but the
stock price has gained more than 670%. "The Internet," Mr. Penney says,
"is the only game in town."
The problem of Internet drain is particularly acute for those unfortunate
money managers -- some pension funds and the like -- whose charters
require them to invest in stocks of small companies that are profitable.
"There are a lot of portfolio managers" stuck in situations like that, Mr.
Penney says.
Look, no one's saying the Internet isn't for real. "There are lots of
companies out there that some day will make a lot of money. But finding
those companies, and finding the right time to buy them, is the hard part,"
Mr. Penney says.
Moreover, they will have to start making money one of these days. "All
these companies not making money and living on fumes have to pull it to
the bottom line," Mr. Penney says. "The ones that can will survive, the
others will go to oblivion."
Mr. Tracey at OppenheimerFunds analyzes Internet companies by
projecting when they will finally earn money, putting a price-earnings
multiple on that eventual profit -- and discounting the resulting stock price
severely, by 35% a year or so, to see if the stock is worth the investment
risk. He spreads his risks by putting only small amounts of money in a
bunch of stocks -- and hoping that the few big winners will outweigh the
likelihood of many duds.
It's more art than science. Often, stock prices are "in the hands of day
traders," or rapid-fire online investors, who don't worry about earnings or
discounts, he says. "Those of us trying to do some kind of serious rational
job on this have to cope with a pricing mechanism that's independent of
analysis." (Recently, Mr. Tracey cut many of his Internet holdings in half.)
Of course, in a weird way, the study makes some sense: The biggest
growth potential is for companies losing money because they have more
room to grow than profitable ones, right?
But you have to look at why companies are bleeding. Sometimes, stocks
are losing money due to the accounting treatment of their business
investments. "Any business where you have to do all your capital spending
up front, and start absorbing depreciation immediately," will show losses,
says Larry Marx, a money manager at Neuberger Berman.
One example, in which Mr. Marx nevertheless invests, is cable stocks. Mr.
Marx figures the cable companies won't have to replace the cable they
have laid anytime soon, and he monitors companies' cash flow to see how
the business is really doing.
Money-losing Internet stocks are another matter. Since they can sell their
stock at high prices, "Wall Street gives them equity for free," Mr. Marx
says. This encourages Internet companies to keep spending more than they
earn to expand market share, because "Wall Street will continue supplying
them with money."
However, unlike the accounting-driven losses at cable companies, "those
are real losses" at Internet companies. It's hard to put a value on them, Mr.
Marx sighs. "These are goofy times."
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