TCS Daily


It's a Small World

By James K. Glassman - May 14, 2002 12:00 AM

I wish I had written this column in January. Back then, I was researching an article just like this one -- about bargain-priced small-company stocks, a category called "small-cap value." So I went to an expert on the sector, Jay Weinstein, president of Oak Forest Investment Management, a money-management firm in Bethesda, MD. "What do you like, Jay?" I asked him in my e-mail of four months ago.

"My buy list is the shortest it has ever been," he responded, with typical circumspection. He recommended just two companies and warned that "my firm owns significant positions and these are relatively illiquid stocks, so caveat emptor, as always."

The first was Advanced Technical Products, a small defense contractor that, according to Weinstein, "had a major problem with fraud at a subsidiary two years ago, which killed the stock, but it is mostly behind them." In January, shares were trading at $18, a price-to-earnings (P/E) ratio of about 11, based on 2001 earnings. Weinstein said in his note, "I expect it to be acquired at some juncture for around $30." Well, that juncture arrived on May 2, when General Dynamics announced it was buying Advanced Technical for $33.50 a share.

The other stock Weinstein recommended at the time was Penford Corp., a specialty chemicals company serving two industries: paper and food. "High energy costs and the downturn in the paper industry killed them last year," Weinstein wrote, but Penford's assets are worth double its stock price, the food industry is "an excellent growth driver," and Penford even pays a dividend. Trading below $13 in early January, Penford closed Friday at $16.69. Not bad. Penford is covered by just one analyst, who predicts earnings of 75 cents for this fiscal year (ending in August) and $1.45 for next.

Unfortunately, I got sidetracked and wrote about something else in January. I'll get to Weinstein's new recommendation (yes, just one) below.

But here's the lesson: Even in this miserable environment, some stocks are rising, and some investors are profiting. For example, on Friday, May 3, the Dow Jones industrial average tumbled 85 points, losing about 1 percent of its value. But that same day, 251 New York Stock Exchange stocks hit new highs -- their loftiest prices in 52 weeks -- while only 42 hit new lows. How do you find them? There's no single method for picking winners, but lately tiny companies with low valuations have been standouts. Prospecting for winners in this category isn't easy. Few professionals cover the stocks, and the companies tend to be in out-of-the-way businesses and lack flashy brand names.

Small-caps are generally defined as having a market capitalization (number of shares times price) of less than $2 billion, and a value stock typically has a P/E or price-to-book (P/B) value ratio that's below the average for the benchmark Standard & Poor's 500-stock index. The average P/E ratio right now is a whopping 46, but that's an anomaly since "E" is so low in a recession year. With normal earnings, P/E should be about 25 and P/B about 5.

Last year, funds that fall in the small-cap value category scored an average gain of 17 percent, according to Morningstar Mutual Funds. That compares with a loss of 23 percent for large-cap growth funds, a loss of 5 percent for large-cap value funds, and a loss of 9 percent for small-cap growth funds. The best of the small-cap value group in 2001 was Heartland Value, up 29 percent, and it's ahead by 7 percent for the first four months of 2002. Over the past three years, Heartland has beaten the S&P 500 by a total of 74 percentage points.

Milwaukee-based Heartland has been managed by William Nasgovitz since 1984. It has an expense ratio that's about average at 1.2 percent, but it requires a fairly stiff $5,000 investment to start. Top holdings include U.S. Oncology Inc., a physician-practice management company that focuses exclusively on treating cancer (P/E ratio: about 17, or less than two-thirds of the current average), and URS Corp., a construction services firm (P/E, 13).

Another small-cap value fund with a superb track record is Royce Low-Priced Stock, which has produced average annual returns of an incredible 21 percent over the past five years, beating the S&P by more than 14 percentage points annually. Leading holdings include Topps Co., the trading-card and bubble-gum folks, whose stock has dropped 20 percent since the beginning of the year and now trades at a P/E of 16, and Industrie Natuzzi, a furniture maker based in Italy with American depositary shares trading on the New York Stock Exchange under the symbol NTZ (P/E, 10). Royce & Associates specializes in small-cap value and has several other funds worth considering: Royce Premier, Select, Total Return and Micro-Cap (up 20 percent for the first four months of 2002). Another small-cap value family with fine results is Marty Whitman's Third Avenue funds (Value and Small-Cap Value).

But back to Jay Weinstein. You may remember him from years back, when I wrote about his recommendations Riser Foods, a distributor, and T/SF Communications, a business publisher. Both were bought out at nice prices. Often, the stocks that Weinstein discovers are cheap because of some apparent problem, which, on investigation, he might find to be overblown. Other times (rarely, but it happens), stocks are cheap just because analysts and investors have missed them. What does Weinstein like now? Atrion Corp., a medical products company with a high-tech system for delivering fluids. It's based in Allen, Tex., and trades at a P/E of about 13. Earnings have been increasing over the past five years at an annual rate of 48 percent, and there's no short-term debt. Atrion has a market capitalization of only $50 million and, since there is little trading and not many shares outstanding, it is "very, very, very illiquid," says Weinstein. In other words, if you own the stock, you may have to knock the price down to find a buyer. When you buy small-cap value -- especially very small, or micro-cap, value, then you have to make a long-term commitment.

To many investors, "value" means sluggish, but Atrion, while certainly risky, appears to be the kind of company that is growing but still inexpensive. Its latest earnings report, out in early May, showed profits rose 26 percent.

But Weinstein frets. His sector has suddenly become too popular. "It was only two years ago that small-cap funds were being liquidated and value managers were practically hung in effigy," he says. "Now, small-cap funds are having to close to new money. If that isn't a danger signal, I don't know what is."

One of the most popular small-cap value funds, Fidelity Low-Priced Stock, which was up 27 percent in 2001 and another 10 percent for the first four months of 2002, recently announced that it would not take any more new investors after May 16. Despite an upfront load of 3 percent and annual expenses of another 1 percent, the fund has been swamped with new investors and has more cash than the manager can adequately handle.

And it's certainly true that the small-cap value has had its ups and downs. From 1998 to 2000, the sector fell by about 9 percent while the S&P was rising by more than one-third. Still, during the entire decade of the 1990s, when go-go high-tech stocks ruled, the small-cap value sector returned an annual average of 14.8 percent, beating small-growth and large-value (but not large-growth, which returned a hefty 19.9 percent). More remarkable is the finding of Ibbotson Associates, the Chicago research firm, that from 1926 to 2001, an investment of $1,000 in small-cap value stocks rose to $22.6 million, beating every other category. Small-cap growth rose to only $731,000.

High returns indicate high risk. Small-caps are far more volatile than large-caps and value is more volatile than growth. But, surprisingly, Ibbotson found that small-cap value was less risky (by a tiny bit) than small-cap growth. Like mid-caps, which I discussed last week, small-cap value companies offer an attractive blend of risk and return.

Some numbers: Large-cap growth stocks returned an annual average of 9.6 percent between 1926 and 2001 and had a standard deviation (a popular risk measurement) of 20.1 percent. Small-cap value stocks returned 14.5 percent with a standard deviation of 32.1 percent. Certainly, you shouldn't put all your eggs into the small-cap value basket, but you could consider keeping at least 10 percent of your money there. Weinstein may be right to issue his warning, but even if small-cap value stocks are getting too popular, that doesn't mean you can't find great companies in this sector that are being overlooked. It also doesn't mean that, even if small-caps fall in the next few months, they won't rise eventually and strongly -- as they have time and again.

A version of this article appeared in the Washington Post.

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