TCS Daily

Investing Small Pox?

By James K. Glassman - October 1, 2002 12:00 AM

Do you have the stomach, in this queasy market, to search for bargains and actually buy some stocks? The worst major sector this year has been small-cap growth, and it stands to reason that this may be the happiest hunting ground.

So far in 2002 (through last Monday), mutual funds whose portfolios focus on small-cap value stocks have fallen 16 percent. Understand, that's good in this environment. By contrast, funds that concentrate on small-cap growth have dropped 32 percent. Since the bear market began 30 months ago, the value half of the Russell 2000 small-cap index has actually risen 24 percent, but the growth half has fallen 60 percent, a huge divergence.

A few definitions: "Cap," of course, means capitalization, or the stock market value of a company, derived by multiplying the number of shares a company has outstanding by the price of each share. There's no strict definition, but in general small-caps have a market cap of less than $2 billion; mid-caps, between $2 billion and $10 billion. The vast majority of stocks - about 80 percent - are small-caps, but they represent only about 15 percent of the capitalization of the entire market.

Usually because their earnings have been rising at a rapid clip, "growth" stocks carry high valuations - that is, price-to-earnings (P/E) and price-to-book (P/B) ratios. P/E measures how many dollars investors are willing to pay for a dollar of a company's profits, and P/B measures how much they are paying for a dollar of a company's net worth on the balance sheet. The stocks of the Dow Jones industrial average last week had an average P/E of 21 and an average P/B of 3.2.

This year, investors have shown that if they want anything, they want value - that is, safe, solid citizens. That makes sense: The high valuations of growth stocks depend on future increases in earnings, and with the future so uncertain, the chance for increased earnings is uncertain as well.

Still, many small-cap stocks have been increasing their earnings at a remarkable pace, despite the economic slowdown and fears of terrorism and war. They tend to be in niches that protect them from competition - because their sectors are too small to interest the big guys or because they have developed reputations for making high-quality products, the kind that people need despite a poor economy.

A good example is Corinthian Colleges Inc. (symbol: COCO), a stock that's recommended by Jim Collins, whose OTC Insight has been the best stock-picking newsletter over the past 15 years, according to the Hulbert Financial Digest.

Corinthian is a for-profit company that provides postsecondary degrees in areas such as business, health care and criminal justice. Especially in tough times, people want to upgrade their skills to keep their current jobs or move on to better ones. The company's fiscal year ended in June with revenue up 39 percent and net income up 51 percent, and Collins projects profit will jump an additional 66 percent over the next two years.

Another fast-growing stock, one Collins considers "exceptionally attractive," is Wintrust Financial (WTFC), a bank holding company in Illinois. With a market cap of $500 million, it trades at a P/E of 20 - high for a bank - but it increased profits in the first half of the year by more than 50 percent. Wintrust, like a good niche player, "has positioned itself to be the local alternative to the 'big banks' in the affluent underserved markets in the Chicago area," writes Collins, and in an interest-rate environment like this one, well-run banks can borrow low and lend high.

Before you rush out and buy these two, realize that Corinthian shares have risen 80 percent in 2002, Wintrust 50 percent. But they're unusual. Most small-cap growth stocks have the plague; no one wants them. While large-cap value funds have beaten large-cap growth funds by about 6 1/2 percentage points, the gap between value and growth among small-cap funds is more than twice as wide. What's going on?

"In part," writes an analyst with the Dow Theory Forecasts newsletter, "the domination of [small-cap] value stocks reflects an unwinding of a giant performance gap. For the three years ending February 2000, Russell 2000 Growth soared 107 percent, compared to a 22 percent return for Russell 2000 Value."

Such extreme cycles in value and growth stocks are common. For example, small-cap value beat small-cap growth in every year between 1981 and 1988, rising 267 percent to growth's 40 percent. But growth whipped value in stretches such as 1932-'35, 1937-'40 and 1988-'91.

It's almost impossible to pick turning points in these cycles; sometimes they last for a couple of years, sometimes for nearly a decade. But it's clear that if you're a long-term stock investor, the current public distaste for small-cap growth is excellent news. As a result, Dow Theory Forecasts contends that "there is a good chance these fast growers will outpace the market for the next two or three years."

One obvious reason small-cap growth has fallen on hard times is that this is the sector where Internet and other exotic money-losing high-techs reigned. But there are lots of intriguing companies in the sector today that put technology to use in reasonable ways - and score consistent profits as a result. Dow Theory Forecasts, for instance, suggests these three selections in high-tech health care: Renal Care (RCI), which provides kidney dialysis services at 200 clinics; Lincare (LNCR), respiratory therapy for in-home patients; and Steris (STE), sterilization services for hospitals. Each has a market cap of about $1.5 billion and a P/E ratio in the 20s. Each is expected to boost its earnings by at least 15 percent this year.

Other small-cap growth stocks recommended by the newsletter include Catalina Marketing (POS), which generates coupons at supermarket checkouts; Quality Systems (QSII), whose software helps doctors manage their patient records, insurance claims and billing; and Copart (CPRT), which auctions cars that have been stolen and recovered.

Catalina trades at a P/E of 25 after falling by one-third from its February high despite powerful growth. Earnings have doubled since 1998, and analysts expect an increase of 20 percent this year. Quality Systems, with no debt, has increased its earnings by an average of 50 percent for the past two years, and yet it trades at a P/E of just 18. (At a market cap under $100 million, Quality is really a micro-cap.) Copart stock plummeted recently after one analyst cut its rating, but the company boosted profit 20 percent in its most recent quarterly report. Copart's earnings trace a Beautiful Line (a concept explored in previous columns), rising year after year, but the firm has had to plow lots of money into capital expenditures to stay on top.

I find companies like Copart and Corinthian fascinating, but it's understandable that many investors shun them in favor of bigger companies with household names. But not all brand-name companies are large-caps. Consider Church & Dwight (CHD), maker of Arm & Hammer baking soda, Brillo scouring pads and Arrid antiperspirant. At a market cap of $1.3 billion, a P/E of 24 and earnings growth this year of 20 percent, Church & Dwight is definitely a small-cap growth stock. It's one of the top 10 holdings of Sentinel Small Company fund (SAGWX), which has turned in a spectacular performance over the past three years with an average annual return of 12 percent.

I'm afraid, however, that Scott Brayman, the new manager of Sentinel, has strayed. He's become "rather timid compared with many small-growth managers," writes Langdon Healy, a Morningstar analyst. Brayman has moved the fund into the "blend" category, between growth and value. His average stock has a P/E of just 17 and a book value of 1.7.

For pure growth, my favorite fund remains Baron Small Cap (BSCFX), with a return of 11 percent over the past 12 months (through last Monday). The fund has whipped the S&P by an average of 13 percentage points annually for the past three years and the Russell growth index by 16 points.

The average stock owned by Baron's manager, Clifford Greenberg, has a P/E of 33, and his number one asset by far is another for-profit chain of schools, Career Education Corp. (CECO). Other holdings include Iron Mountain (IRM), which manages records for businesses and has been increasing its earnings at about 15 percent annually, and Viad Corp. (VVI), which provides services to conventions and trade shows and carries a P/E of 25 after falling one-third in price this year.

Wasatch Small Cap Growth (WAAEX) has an even better record than Baron, but it's closed to new investors. Still, you can cull a few good ideas from its most recent list of holdings. Heading the list are AmSurg Corp. (AMSG), which operates walk-in surgery centers that perform routine procedures such as tonsillectomies, and O'Reilly Automotive (ORLY), a well-managed chain of 870 auto-parts stores. AmSurg, with a market cap of $550 million and a P/E of 28, is expected to increase its earnings by more than 40 percent this year. O'Reilly's growth rate for profits is an impressive 20 percent.

Recently reopened to investors is Wasatch Micro Cap (WMICX), which owns some of the same stocks as Small Cap Growth, including AmSurg. Micro Cap's median market cap is just $400 million, compared with about $900 million for the other Wasatch fund, and its manager, Robert Gardiner, tends to lean a little more toward value. Still, Micro is a bona fide small-cap growth fund, and its performance history has been sensational. Over five years, $10,000 invested in Micro Cap grew to $28,000; in Small Cap Growth, to $17,000.

Two drawbacks: First, Micro carries an astronomical expense ratio (2.3 percent, nearly twice as high as Baron). Second, Micro has had a rough year in 2002: down 29 percent. Of course, when you are searching for bargains, lousy returns can be a very encouraging sign.



TCS Daily Archives