Smaller stocks can shine bright, says Templeton Group

 November 5, 2015, Thursday

KUCHING: When markets are volatile and uncertain, many equity investors often gravitate toward the larger companies they perceive to be the most stable—in the form of large-cap stocks.

However, Templeton Emerging Markets Group believes within the emerging-markets universe, it sees a number of small-cap stocks with shining potential that should not be ignored.

According to Dr Mark Mobius, executive chairman of Templeton Emerging Markets Group, they have found that as an asset class, emerging-market small cap is one of the most widely misunderstood and underutilised among investors.

“It is often perceived to be a place to avoid in times of uncertainty, but we see things differently.

“Many small companies are driven by local market dynamics and are therefore less dependent on global market trends,” he said.

Mobius went on to note that the small-cap emerging-market universe is anything but small—there are thousands of small-cap stocks available to invest in today, and the investment universe continues to expand due to the gradual liberalisation of equity markets to foreign investors and the continued expansion of equity markets through initial public offerings, secondary offerings and privatisations.

Among the many reasons to consider investing in small-cap stocks, smaller companies in emerging markets are generally privately owned, competitively operated, more local and are often larger players in smaller industries, Mobius said.

“Aside from relatively high organic growth compared with most larger companies, industry consolidation and acquisitions by larger companies as well as increased investor attention are additional potential sources of growth which can be independent of the broader macroeconomic environment.

“Many of the stocks in this space are under-researched or unloved, giving us the opportunity to uncover interesting opportunities others may have overlooked.

“We see that as the essence of what investing in emerging markets generally is about—discovering undervalued stocks in burgeoning markets that could rise to become tomorrow’s stars,” he said.

Mobius went on to note that the Asian small-cap space is of particular interest to them, and they have been using recent market volatility to search for opportunities.

“We believe reforms taking place in many emerging markets in the region could prove to be beneficial for smaller companies.

“Additionally, since domestic demand is typically the main revenue driver for small-cap companies, the combination of good economic growth, a growing middle class and lower oil prices—which can help check inflation and support a lower-interest rate environment—could be an added benefit to smaller companies in the region, freeing up consumer dollars to purchase their products,” he added.

Mobius noted that within the small-cap space in emerging Asia, they currently favor consumer-oriented companies given the growth opportunities they see across many markets, as well as health care, pharmaceuticals and biotechnology companies.

He further noted that this of course does not mean these companies are all well managed or worthy of investment.

“Therefore, purchasing small-cap stocks through a passive (index-based) strategy may produce unintended consequences.

“Stocks with poor growth prospects, poor corporate governance or other such factors may be components of a small-cap benchmark index, but they might not be desirable to invest in over the long term,” he said, adding that regular index rebalancing can generate significant portfolio turnover for passive investors.

“We strive to generate alpha1 through our bottom-up stock selection process, looking for companies that we think can increase their market cap by a multiple over a five-year time horizon, and we strive for only modest yearly turnover,” Mobius said.

On risk, Mobius pointed out that it is certainly an important part of a discussion about small-cap investing.

“I’ve never met a client who complains about upside risk. What worries clients is downside risk, and this is where we think we add value as active investors.

“Our team maintains an unrelenting focus on quality, seeking fundamentals that are on almost every measure superior to a benchmark index, including higher return on equity (ROE), profit margins and earnings-per share (EPS) growth, lower debt, better dividend yield, and most importantly for us at Templeton, cheaper valuations in terms of priceearnings ratios,” he said.

Mobius noted that contrary to many investor assumptions, the emerging-market small-cap benchmark index, as measured by the MSCI Emerging Markets Small Cap Index, at times has been less volatile than the broader index, the MSCI Emerging Markets Index, as well as the Russell 2000® Index, a US small-cap benchmark.2

“To us, that makes sense because small-cap companies are less correlated with each other, and less integrated into global markets than large caps generally speaking,” he said.

Mobius further noted that there are also numerous inefficiencies in small-cap markets, offering potential for alpha.

In the US, small-cap stocks generally trade at a premium to large caps in terms of price-earnings, due to the higher growth they can provide, he says.

“When you look at emerging markets, sometimes the opposite may be true. In India, for example, small caps are generally trading at a discount to large caps.

“Much of this investment money is what we’d call ‘lazy money’, or passive investment money, concentrated in large-cap index stocks that are not only more expensive but also subject to the volatility generated by rapid inflows and outflows of such foreign investments.

“Accordingly, we have found many undiscovered opportunities in Indian small caps,” he added.

Overall, Mobius noted that small-cap stocks have the potential to offer what is becoming ever-more rare in a slowing global economy—growth—and not only in India.

“Many emerging markets offer this strong growth potential—with many small-cap stocks available to potentially take advantage of it,” he concluded.

Read more: http://www.theborneopost.com/2015/11/05/smaller-stocks-can-shine-bright-says-templeton-group/#ixzz3qwWxvQi3

Making investing enjoyable, understandable and profitable… A Simple and Obvious Approach

Making investing enjoyable, understandable and profitable…

Is it not true, that the really big fortunes from common stocks have been garnered by those 

• who made a substantial commitment in the early years of a company in whose future they had great confidence and who held their original shares unwaveringly while they increased 10-fold or 100-fold or more in value?

The answer is "Yes."

The Second Secret of Small-Cap Investing: Invest for the Long Term (but Monitor in the Short Term)

Successful stock investors know that a long-term approach often pays off by allowing individuals to ride out a company’s temporary setbacks and realize gains over a period of five years or a decade or even longer. In addition, minimizing transaction costs and short-term capital gains taxes can add to the overall rates of return.

With small-cap stocks, however, some tweaking to the buy-and-hold strategy used in a large-cap stock portfolio may be necessary. Because smaller companies are less established, there is often a higher degree of risk and volatility involved in holding these kinds of stocks. That’s not to say that a buy-and-hold approach can’t work, though, but just a reminder that “buy and hold” does not mean “buy and forget.” With small-cap stocks it can be prudent to maintain a somewhat higher level of vigilance on their activities, watching for signs of trouble and selling promptly when real problems affect a company.

When problems do arise, the market is often less forgiving of small companies when they hit roadblocks. Even when management eventually steers these companies back in the right direction,investors may stay away until they are receive excessive degrees of reassurance, keeping stock prices depressed all the while.

It’s never good to be swayed into action by irrational market moves, however, and patience is frequently required to become a successful stock investor. Smaller companies often don’t have the broad institutional interest required to support share price growth. As a result, stock prices may only grow moderately until a tipping point is reached, at which the market seems to wakes up to the potential of a company. Investors who have already discovered the stock will then be nicely rewarded.

http://blog.betterinvesting.org/investing/five-secrets-of-small-cap-investing-part-two/

The First Secret of Small-Cap Investing: DEMAND PROOF OF MANAGERIAL EXCELLENCE

Great businesses are made, not born. And the secret to making a great business is having solid leadership in place — a management team that can drive a company on the route to sustainable excellence.

As with any stock investment, it’s imperative to establish that a small company’s leaders are more than competent — they have the skill and expertise to deliver profits to shareholders. Although there are many ways to determine whether a company’s management team is up to the task, a few factors rise to the top.

First, a company should have an operating history of at least three years. For companies that have recently gone public, this period could include years before its initial offering. There should have been no jarring changes of management during the company’s recent past as well. A company’s management can’t be evaluated without evidence, so the team responsible for the success of the venture to date must still be in place in order to make judgments.

Second, a company must be profitable to be considered for investment. The promise of future profits is not sufficient. Nor is it enough for a company to have recently turned the corner and posted positive earnings for the first time in its history. If a company has been able to deliver several recent years of profitability, management has passed the most important test of its skills.

But it’s not enough that a business’s management is merely competent. Our third suggestion is that stock investors strive for excellence — seek companies that meet or surpass the performance measures of their peers and competitors.

Fourth, the strength and consistency of historical growth is certainly area where investors can discern the hand of management in building a business poised for long-term future success.

Fifth, the trend and level of a company‘s pretax profit margins is perhaps the single most important comparative factor. Successful, quality companies can be identified by the margins they eke out on each dollar of revenue. Higher margins than competitors are almost always a sign of management expertise. Relatively stable annual margins are demanded of all companies. Growing margins are a positive.

To be sure, smaller companies may be in the phase of building their business, investing now to support greater success in the future, so the analysis of margins when compared with more established competitors should keep this possibility in mind.

A company’s return on equity should be reviewed carefully, but this measure not be less useful as a quality consideration for newer-stage businesses. Smaller companies can earn higher returns on initial equity, but these levels are not sustainable. Caution must again be exercised when comparing small businesses with established enterprises. Finally, any company included in a growth stock portfolio must have identifiable drivers of future growth. Tailwinds should be stronger than headwinds. No business can coast to success on the coattails of its past success, so management must be able to present a viable vision for how it intends to grow the business in the years ahead.

http://blog.betterinvesting.org/?p=2417

Midsize Stocks - A Good Choice for Anyone's Nest Egg

It isn’t easy to find a stock that has the magic — an enticing financial elixir that combines stability with the promise of a decent rate of growth.

• Large-company stocks are relatively stable but move too slowly for many investors. 
• Small-company stocks’ value can rise quickly but could be seen as a gamble at a time in which investors aren’t exactly excited by the notion of taking on added risk. 

Say the experts: Find the middle. “The $2 billion to $7 billion market-cap range is really a sweet spot in the market,” says Don Easley, portfolio manager of the T. Rowe Price Diversified Mid-Cap Growth Fund.

“There are a lot of interesting companies in that area and there’s certainly a place for mid-caps in anyone’s portfolio.”

Stocks at these midsized companies aren’t called the“sweet spot”without reason. Indeed, the class of stocks that not too many years ago were classless — lumped in with large-cap stocks — has outperformed their larger and smaller peers. 

BetterInvesting uses annual revenue to determine a company’s category.

• For instance, midsized companies have annual revenues between $500 million and $5 billion. 
• Small companies have revenue below $500 million and 
• large-company revenue weighs in at more than $5 billion.

http://www.betterinvesting.org/NR/rdonlyres/9D3D3176-4E81-4D5D-90F7-19879D031A6A/0/cs.pdf

Screening for Mid-Size Companies

The companies screened should satisfy the following conditions:

1.  Past performances

• trailing-12-month revenues of between $500 million and $5 billion;
• five-year sales and earnings growth of at least 12 percent.

2.  Projected future performances

• forecasted five-year annual earnings and sales growth of 12 percent; and 
• a projected annual total return for the next three to five years of at least 12 percent. 

Also, look for Financial Strength and Earnings Predictability. 

As with any stock screen,this is just a starting point for research; no investment recommendations are intended.

Also, make sure any company of interest looks suitable on a Stock Selection Guide using your own judgments.

Investing: how small UK companies can boost your wealth

Paul Marriage, manager of the Cazenove UK Smaller Companies Fund, tells Robert Miller why investors should ignore the 'noise' of macro economic news and look at smaller and profitable companies in the UK.

http://www.telegraph.co.uk/finance/financevideo/yourmoneytheirhands/9100964/Investing-how-small-UK-companies-can-boost-your-wealth.html

Discerning Growth from Value

Growth versus Value Stocks

Growth companies are those that are growing sales and earnings every year. Their stock prices are rsing, their profit margins are big, and their expectations are high.

Value companies are trading at low prices (relative to their intrinsic values). The low prices are usually the result of tough times at the company but occasionally just because the market is a weird place. Preferably, you buy a value stock just when it has fixed its troubles and begins to profit again, or just before the market discovers its discount price.

Often the best growth investments are smaller companies. Of particular importance in evaluating growth companies are high earnings record, high relative strength and low price-to-sales ratios. O'Shaughnessy found price-to-sales a great measure to mix with traditional growth yardsticks because it keeps growth investors from getting too carried away with emotion and paying too much for a stock.

The best value plays are usually large companies. Not always, but most of the time. Large companies don't change much and that makes them prime candidates for bargain pricing. They are not going anywhere, after all, so they have no choice but to recover from whatever trouble they're in. For such companies, traditional value measures will be your focus. Those are dividend yield, P/E, price-to-book, and price-to-sales.

The Illusion of International Small-Cap Investing

The Illusion of International Small-Cap Investing

Drew Spangler
Grantham, Mayo, Van Otterloo & Co. LLC
March 2001

Investing in international small-cap is a complicated and deceptive business.  Many of the common assumptions used to justify international small-cap investing are misguided.  The sticker must read “caveat emptor.”


Many investors are attracted to international small-cap because they believe that small companies are capable of faster earnings growth.  They reason that higher growth rates will lead to superior performance.  But the great irony of small-cap investing is that these companies do not grow any faster than their larger peers.  

• In fact, the corporate financial performance of international small companies is below average.  
• The small universe is populated with mediocre companies because the common definition of small contains an implicit bias for stocks with low valuations.  
• Low stock valuations are often the consequence of inferior corporate results. 

However, the hidden tilt towards value stocks actually provides the international small sector with the engine for excess returns and ironically enables international small-cap investing to be potentially very lucrative.  In addition, this value bias can be used to assess the future prospects for small stocks in the international equity markets.  This paper seeks to reveal the true identity of international small stocks and thereby equip investors with the information, insight and tools.


Executive Summary

Investors are beginning to awaken to the compelling case for small stock investing in the international markets. Recent outperformance, low valuations and increasing diversification benefits are all reasons investors are becoming attracted to this sector. Before they jump in head first, however, investors need to be aware of a few issues that make assessing the risks and rewards of international small stocks more challenging.

1. First, it is not entirely clear how to define small-cap and there is a diversity of opinion about what method is most appropriate for identifying the small universe. In this paper, we compare and contrast the construction methodologies of the two leading international small-cap indices.
2. Second, most conventional methods for defining small use market capitalization to measure company size.This introduces an implicit bias for companies with low stock valuations relative to corporate fundamentals such as earnings or assets.
3. Third, it is the quality of cheapness rather than smallness that drives small stock performance and is a powerful tool for forecasting the future performance of these stocks.
4. Fourth, although investors are often tempted by small-cap because they perceive these stocks to be capable of higher earnings growth, our empirical analysis shows this to be a fallacy.  In fact, the fundamental corporate performance of small stocks is below average.

Finally, the diversification benefits of international small are alive and well. Not only have correlations with international large stocks decreased, but international small continues to be asynchronous with both US large and US small stocks.

In conclusion, while international small stocks currently present a compelling opportunity, investors need to be educated and informed in order to take full advantage of this potentially lucrative sector.


Read the full report here.

Big returns come from small caps

Big returns come from small caps


John Collett asks the experts for their top investment tips among our smaller companies.

The accounts of our biggest listed companies are pored over endlessly by an army of analysts, which makes it unlikely that investors are going to come across hidden value among these giants.

Smaller medium-sized companies, on the other hand, are usually less visible so they provide potential to uncover hidden value and big capital gains. For investors who are patient and prepared to invest over the long term, smaller companies can add some zing to share portfolios.

Money asked leading small-cap fund managers and analysts for their tips from among those market minnows with well-established track records and a history of paying reliable dividends. Like any sharemarket investments, there are always risks. And smaller companies come with more risks than large companies. Their earnings tend to be the most responsive to economic conditions - both good and bad.

Shares should never be held in isolation but in a diversified portfolio. Many investors may find a better way to get exposure to smaller companies is to invest with a specialist smaller companies fund manager. Professional fund managers run portfolios holding dozens of smaller companies, providing small investors with instant diversification.

The stocks nominated by fund managers and analysts cover the spectrum of the Australian economy - retailers, financial services, technology - but there are no resources stocks. Smaller resources stocks may be terrific investments but are too speculative for novice investors.

TURNAROUND STORY

The managing director of Perennial Value Management, John Murray, nominates OrotonGroup, which designs and makes luxury handbags, leather goods and accessories. Murray is a fan of the managing director, Sally Macdonald, who since her appointment in 2006 has turned the struggling retailer around. The company has expanded product lines and refocused on key brands including Polo Ralph Lauren and Oroton. Murray still has the Oroton briefcase he bought in 1991 and says the brand is "classic value fashion" - quality fashion that is not too expensive.

"We are believers in Oroton and growth will be driven by new stores and product lines like lingerie and menswear," Murray says. Perennial first bought Oroton shares for $3 each in 2007. The shares are now trading at about $7. As a luxury fashion retailer, the company's sales are vulnerable to down-turns in the economy. A little over a year ago, towards the tail-end of the GFC, Oroton shares dipped to $2.80 and in the year since, Oroton's share price has increased 250 per cent.

Before it will invest, Perennial has to be convinced of the strength of a company's balance sheet. And Oroton has good financial strength with low debt, Murray says. On a share price-to-earnings multiple of 11 times, Oroton shares are not cheap but they are still reasonable value, he says.

PIPING HOT

Reece Australia, a plumbing supplier, has many of the attributes the small companies fund manager and chief investment officer of Celeste Funds Management, Frank Villante, likes to see. House prices are rising and spending on renovation is healthy, which means Reece is "fantastically positioned" to take advantage of the trend.

Reece is a conservatively managed company, owned by the same family since the 1930s, and family interests own about 70 per cent of Reece shares. Australian corporate history is littered with examples of majority owners treating minority shareholders shabbily. However Villante says the Reece family has a long history of treating such investors well.

The company has a market capitalisation of about $2.5 billion, which puts it just inside top-100 companies. The company owns about $250 million of land and buildings and Reece's management takes the view that property in the right areas can be an attractive long-term investment. Reece is No.1 in terms of revenue, number of stores and on just about every measure Villante can find. Reece has no debt on its balance sheet; it is carrying about $60 million in cash. Villante is expecting earnings to grow at more than 15 per cent a year between 2011 and 2014.

WEB WONDER

The co-founder of Smallco Investment Manager, Rob Hopkins, is excited about the prospects of the internet sector.

Hopkins particularly likes the well-established internet employment website, Seek, which he says has a "very impressive" management team led by the Bassat brothers who, together with Matthew Rockman, founded Seek in 1997. Rockman left the company in 2006.

Seek expanded into New Zealand and has investments in employment websites in China, Brazil and Malaysia. It owns more than 40 per cent in Zhaopin, one of China's three leading online employment sites.

Seek shares have had a big run. A couple of years ago the stock was $2; it is now $8 and is on a price-to-earnings multiple of 23 times, which is expensive, Hopkins says. With a market capitalisation of $2.8 billion, it is not a market minnow and is just inside the top-100 companies but still has plenty of growth potential. "We expect earnings-per-share growth of more than 40 per cent over the next year," Hopkins says. In internet commerce there is not much room for No.2 and No.3 players. "People looking for a job go to a site where they know all of the jobs are advertised," Hopkins says, adding that the internet sector has plenty of examples where the No.1 player makes very good returns, while the No.2 player is just profitable and the third-placed player loses money.

GRIM REAPER

Fortune favours the grave with InvoCare Limited, which provides funeral homes, burial services, cemeteries and crematoria around Australia and in Singapore. Invocare operates two national brands, White Lady Funerals and Simplicity, and is the only funeral services provider that has a national reach.

InvoCare listed in 2003, having been built up during the 1990s under the ownership of a US funeral services operator and private equity investors that have since sold their shares in the company.

"It's amazing, what we call the death-care industry," says Brian Eley, co-founder of Eley Griffiths Group.

"The number of deaths is rising as the population increases and ages. You have that demographic trend, which is positive for the stock."

InvoCare has been a very good performer, Eley says: The stock is not "super cheap" and it never will be because people know that it's such as good business. The fragmented nature of the market presents plenty of opportunities for the company to grow through acquisitions, he says.

As people become wealthier they tend to spend more on their relatives' funerals, Eley says, and a growing part of the business is pre-paid funerals. He also says the funeral care industry has a lot of pricing power, which means the industry can increase prices by a bit more than inflation with little resistance from customers.

InvoCare has prices that are in the mid-range, which benefits the company as the mid-range is where most of the market is, Eley says.

TICKET CLIPPER

Funds management is a wonderful business because it is so scalable. Taking a percentage of funds under management - clipping the ticket, as it is known - has been the source of riches for banks and insurances.

IOOF, a funds management and investment platform administrator, is a very well-managed company, says Steve Black, a fund manager at Pengana Capital. It has a market capitalisation of about $1.3 billion, which puts it at the larger end of the small-cap companies. It pays out about 80 per cent of its profits as dividends and is yielding about 5.5 per cent, fully franked. "It has done very well but we still see very strong upside in it," Black says. "It is a stock that has not been well understood by analysts, which is why it is starting to perform now as more analysts start to recognise that these guys are delivering really good results."

IOOF, led by managing director Chris Kelaher, is one of the big-five platform providers. These are the administration platforms used by financial planners, which provide their clients with consolidated reports on portfolio performances and taxes and enable easy switching between investments. The platform owner levies a fee that is a percentage based on the assets. IOOF has been acquiring platforms and has its own financial planning network. IOOF is considered a possible takeover target by one of the big banks or insurers.

HEALTHY PERFORMER

Blackmores, the natural health remedies company, has very high returns on equity, which analysts say is a good thing because it shows a company is making good use of shareholder funds.

Whether it's arthritis, joint, bone and muscle pain or "brain health", Blackmores, which was started in 1938 by Maurice Blackmore, has a pill for everything.

Greg Canavan, a sharemarket analyst and editor of Sound Money. Sound Investments, a weekly report on the sharemarket, says Blackmores is a "nice little smaller cap" that is tapping into a growing market for natural remedies. It has a strong business in Australia and has established a presence in Thailand and Malaysia. The company distributes its products mainly through pharmacies and supermarkets.

Canavan says $23 a share is a little expensive and would prefer to buy at $20. "In 10 years' time, I think Blackmores will be a lot bigger company than it is now," he says.

http://www.smh.com.au/news/business/money/investment/big-returns-come-from-small-caps/2010/05/11/1273343328362.html?page=fullpage#contentSwap1

OSK expects 50 Jewels to shine

OSK expects 50 Jewels to shine
By Goh Thean Eu
Published: 2010/05/07

OSK Research Sdn Bhd, a unit of OSK Investment Bank Bhd, expects companies that made it to its top 50 Malaysian small-cap list, dubbed "50 Jewels", to register between 5 per cent and 15 per cent growth in earnings this year, driven by their strong fundamentals, as well as a recovery in the economy.

The research house also expects companies in the Top 10 list, which are made up of the 10 best small- cap companies from the 50 Jewels, to post between 8 per cent and 15 per cent earnings growth.

This year, 19 new companies have made it to the 50 Jewels list, including Notion Vtec, Zhulian, Sunway Group, EP Manufacturing, Glomac, AEON Credit and Southern Steel.

"In this edition, we continue to feature 50 of Bursa Malaysia's top small-cap companies, but unlike the previous editions, we have raised the market capitalisation threshold to RM1.5 billion from RM1 billion.


"This is to maintain coverage depth and breadth and to ensure that the better small-cap companies are represented," said OSK Research head Chris Eng in a media briefing in Kuala Lumpur yesterday.

Companies which made it to the 50 Jewels list in 2009 have performed commendably, with 32 of them having posted absolute returns of 50 to 375 per cent, outperforming the benchmark index.

Its top-10 picks for 2009 also posted absolute share price returns of 52 to 347 per cent. Mudajaya, its top construction pick for 2009, rallied 347 per cent.

Meanwhile, the research house expects the local stock market to continue to be volatile over the next three months, mainly due to one of the following factors -

• global bull factor, 
• global bear factor, 
• local bull factor and
• local bear factor.  :-))

"We expect things to stabilise sometime in the third quarter, and then the company's fundamentals and economic fundamentals will drive the market," explained Eng.

In its recent research report, OSK Research targeted the benchmark FTSE Bursa Malaysia KL Composite Index to hit 1,465 points by year-end. It also placed a fair value of 1,580 points on the index in 2011.

Read more: OSK expects 50 Jewels to shine 

The recipe for truly high growth

The recipe for truly high growth has a handful of necessary ingredients. They are:

• A small company
• A wide market opportunity
• Meaningful macroeconomic tailwinds.  

Think, for example, of Amazon.com (Nasdaq: AMZN) when it launched in 1995. It was a tiny company, one of the first e-tailers, and it had the rising tide of the Internet -- merely the greatest development of the past 25 years -- helping it along. Now ask yourself: Do any of the companies or industry opportunities in your surveillance fit that profile at all?

Small Caps: Growing Value And Valuing Growth

Small Caps: Growing Value And Valuing Growth
03/26/01 11:35:03 PM PST
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by David Penn
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With the Nasdaq reeling and the economy teetering on the edge of a recession, why would anyone be interested in small-cap stocks and mutual funds? Growth, for one thing. Value, for another.


It's something that almost anyone can tell you: Small-cap stocks tend to outperform large-cap stocks on the way up and underperform them on the way down. This conventional wisdom, however, was turned on its head in the final, delirious years of the most recently ended bull market. As Greg McCrickard, manager of T. Rowe Price's Small Cap Stock Fund, put it in a recent update on the fund's strategy: "When the markets [are] really moving up and the animal spirits are in the market and people are feeling great ... people have historically looked to small caps to get that extra bit of performance. It didn't happen this time."

What did happen, according to McCrickard and others, was that large-capitalization stocks led the charge to dizzying heights in the spring of 2000 and were among the first, when the overly exuberant valuations of these large-cap companies became suspect, to come crashing down (Figure 1). While the market downturns of 2000 were widespread, the collapse of many large-cap companies may have been an opportunity for small caps. "Given that valuations were very extended for large caps and not so bad for small caps, when we finally had the correction that we saw, small caps actually did pretty well," McCrickard noted.

FIGURE 1: COMPARATIVE PERFORMANCE OF LARGE- AND SMALL-CAP STOCKS IN 2000. The Russell Large Cap Index was down 10%. The Russell Small Cap Index was down 5%.


Much of the wreckage from last year's stagnant Standard & Poor's 500 index and bearish Nasdaq was in the technology sector, so it is little surprise that many of the small-cap companies that did well were outside this arena. Richard Baker, a stock analyst for SmallCapStockNews.com, points to a number of small-cap stocks in the retail area that have done well. Many small-cap value names in the energy sector also fiddled a spritely tune while their technology and telecommunications brethren spent much of 2000 burning. As much of the excess in the stock market continues to drain out and more traditional valuation methods make a comeback, is it time for average investors to pay more attention to small-cap stocks?

WHAT ARE SMALL-CAP STOCKS?

The textbook definition of a small-cap, or small-capitalization, stock is a stock whose company's total market capitalization -- the market value of all outstanding shares -- is between about $350 million and $750 million. Small-cap companies, as one analyst put it, are the "disregarded, unrecognized backbone of America's economy." Often overlooked due to the lack of brand recognition and major institutional backing (some publicly traded small-cap companies have little, if any, analyst coverage, to boot), small-cap companies are nevertheless the small businesses that provide jobs to hundreds of thousands of Americans and often serve as important product suppliers and service providers for larger companies.

Why do small caps tend to outperform large caps? While there is no direct relationship between any given company's market capitalization and its future stock price, there is a strong relationship between a company's market capitalization and that company's ability to raise capital. A company's ability to raise capital to pay for growth and expansion, or to reduce debt, is a major factor in a company's ability to become and remain profitable, and for its stock price to appreciate. Smaller companies tend to have much less capital (in terms of overall assets) to devote to growth and expansion compared to larger companies. Issuing corporate bonds, preferred stock, secondary issues of common stock, bank loans -- all of these are more difficult for smaller companies (say, the RealNetworks of the world) than they are for larger companies (say, the General Electrics of the world).

As such, small-cap stocks usually feature higher risk-return ratios than large- or mid-cap stocks. In other words, because the risks are greater, the potential returns must be greater. This form of risk is often referred to as size risk and is among the risk-return questions that investors must ask themselves when they are searching for investment products to help them meet their goals. Size risk can also play a major factor in properly diversifying a portfolio of stocks or mutual funds. A mix of small-cap stocks in a portfolio overweighted with large-cap stocks can help sustain a portfolio's positive returns when larger issues are failing or not advancing as fast as an investor might prefer.

WHAT SHOULD INVESTORS IN SMALL-CAP STOCKS LOOK FOR?

Analyst Richard Baker has his own mnemonic to help investors remember the key characteristics of small-cap stocks that are likely to appreciate in value. His Miss acronym, which stands for management, innovative and value-added, sector, sales and earnings, helps screen out hundreds of small-cap stocks, making it easier for investors to focus on those small-cap companies that have a background of success and bright growth prospects.

"These four things actually precede a big runup in price appreciation in a given stock," Baker adds. With regard to management, he likes business development experience and, especially, subject matter expertise. Businesses started by industry veterans or those with significant academic credentials and accomplishments can often have insurmountable advantages over businesses initiated with little more than entrepreneurial enthusiasm. In the wake of the dot-com meltdown of 2000, Baker also casts a suspicious eye toward what he calls "concept stocks" -- the shares of companies that might be interesting ideas, but turn out to be lousy businesses. "They sound like a great idea," he points out. "But did they really have a market where they were generating existing revenue from customers who were really purchasing products or services?"

Another interesting aspect of Baker's methodology is his emphasis on sectors. "When you look at buying a house, you look at the proverbial three most important things: location, location, location," he reminds us. According to Baker, that's the same criteria we should keep in mind in selecting a stock: What sector or area of the economy or what industry will experience growth as a part of demographic changes, changes with technology, or changes of consumer needs? In trying to find small-cap stocks in the early stages of their growth phase, he suggests, looking at sectors can be especially helpful. On this score, some of the small-cap stocks that Baker has been impressed with recently include retailers Chico's Fas (CHCS) and Hot Topic (HOTT). (See Figures 2 and 3.)








FIGURES 2, 3: SMALL-CAP RETAILERS. SmallCapStockNews analyst Richard Baker sees strength in small-cap retailers such as Chico's FAS and Hot Topic.


As a small-cap portfolio manager, McCrickard considers his approach to be a quest for both earnings growth and reasonable share prices. "Through a combination of blending growth and value, we can have lower volatility with good returns," he explains. "We look for good businesses; we want to find companies that have reasonably clean balance sheets or the ability through generating lots of cash to get that balance sheet cleaned up pretty quickly."

Another plus as far as McCrickard is concerned is managements that have a large stake in their companies. "We like them to be on the same side of the table with us," he notes. "If they are not just employees, then they are thinking about building value over long periods."

He also thinks that studying sectors can help point the way toward areas of the economy that may be experienc-ing exceptional growth. Says McCrickard, "Really, the sectors of the market tell us where we ought to be investing." While chasing after sector performance can be a tricky game for the average investor, there is little doubt that many of the stocks that see dramatic apprecia-tion in value don't do so alone and are often part of an industrywide, sectorwide, or even economywide (in the case of our recently ended bull market) advance. "In 1993 it was health care, 1994 was technology. In 1995 it was biotech," McCrickard recalls. "You could buy biotech for less than cash on the balance sheet."

At present, he sees opportunities in the often-treacherous technology sector -- though he tends to be less sanguine on pure semiconductor stocks, for example, referring to them as the "tail end of the whip." Nonetheless, some of the companies he has been impressed by include Brooks Automation (BRKS), a company that makes robotic automation arms as well as software for the semiconductor industry, and ATMI, which manufactures consumables such as air-handling equipment for semiconductor companies. (See Figures 4 and 5.)









FIGURES 4, 5: SMALL-CAP TECH STOCKS. T. Rowe Price's Greg McCrickard thinks Brooks Automation and ATMI may be small-cap tech stocks worth watching.


"I know from being an active participant in the markets that a lot of large institutional shareholders are interested in small- and mid-caps," adds McCrickard. "I've made money in large-cap stocks. It is time to diversify and look at small caps."

David Penn can be reached at DPenn@Traders.com.

http://premium.working-money.com/wm/display.asp?art=124

Look before leaping into small stocks

10/29/99- Updated 02:09 PM ET


Look before leaping into small stocks

By John Waggoner, USA TODAY

Your neighbors are all buying stocks. So are your co-workers. Heck, the kids down the street are investing in Lemonadestand.com. You? You're sensible and have most of your money in mutual funds. But you have a little money put aside, and you want to try picking some stocks, too.

The operative words here are "a little" money. You want to spend maybe $2,500, preferably less. If you're buying in multiples of 100 shares - which can save you money on commissions - you're talking about stocks that cost less than $25 a share.

Evaluating such inexpensive stocks isn't as easy as evaluating a large stock like Intel. But it's not that much harder - and it can be rewarding.

Low for a reason

Most investors dream of buying a stock for $1 that turns into a 10-bagger - slang for a stock that gains 1,000%. But don't go that low - stocks priced below $5 a share are considered "penny stocks," and they can be dangerous. "When you get below $5 a share, the stinkers outnumber the 10-baggers," says Joel Tillinghast, manager of Fidelity Low-Priced Stock Fund.

Even stocks that sell from $5 to $20 need to be looked at closely. A $5 stock isn't low-priced by accident, says Robert Kern, manager of Fremont U.S. Micro-cap Fund. "It's that price for a reason."

And that reason is rarely a good one. In the best case, the company missed its earnings estimates for a quarter or two or is in an industry that Wall Street currently shuns. In the worst case, the company is shuffling off to oblivion. "You want to make sure you don't have complete wipe-out risk," Fidelity's Tillinghast says.

Check the numbers

So look for a strong balance sheet. Get the company's annual report and its most recent quarterly reports, either through a stockbroker or find them at the Securities and Exchange Commission's Web site, www.sec.gov.

Your first question: If sales take a serious downturn, does this company have enough money to survive the next 12 months? To get the answer, go to the balance sheet and find:

Current liabilities. This is the company's debt due within 12 months.

Current assets. This is the company's accounts receivable, cash, marketable securities and inventory - items that could be used to pay off current liabilities in a pinch.

Dividing current assets by current liabilities gives you a company's current ratio. You want this to be higher than 1, and preferably much higher. For a more conservative number, called the quick ratio, subtract inventory from current assets. Inventory can be tough to sell in a downturn.

You also should get an idea of the company's total debt vs. its total assets. In general, the less debt the better. How much is too much? It depends on the industry, Tillinghast says.

"Financial companies can support debt levels that would be terrifying to industrial companies."

Next question: Does this company actually make money? For that, look at earnings per share. Tillinghast likes to look for annual earnings-per-share growth of 10% or better. "If it's not 10% or more, I'll look for something better," he says.

And these are just starting points. You should be thoroughly familiar with the company and its fundamentals before you invest.

Different styles

Clearly, it's not easy to find a $10 stock that has no debt and 10% annual earnings growth. In most cases, that's because the company has stumbled recently. You have to figure out why the company's price might rise.

Different managers use different techniques. John Rogers, manager of the Ariel Fund, looks for stocks that are simply out of favor and should rebound. For example, HCC Insurance earned $1.57 a share the past 12 months. Like most property/casualty companies, it got clobbered this fall during hurricane season.

Analysts expect the company to earn $1.20 a share this year, which is short of expectations. But the stock's price is down more than 55% from its July 1999 high, while earnings are expected to be down only 24%. So Rogers figures it's been punished enough.

Erin Piner, manager of PBHG Limited Fund, looks for stocks with strong growth in earnings or sales. Her favorite low-priced stock, Hall Kinion & Associates, supplies staffing for Internet sites. Earnings have risen 58%, from 12 cents a share to 19 cents, and revenue is rising, too. "It's a low-priced way to play the build-out of the Internet," she says.

Most low-priced stocks are small-company stocks, and small-company stocks have been mostly ignored for years. So many of them are historically cheap. "I've never seen anything like it in the past 17 years," Rogers says.

More time and effort

Cheap or not, investing in individual stocks takes more time and effort than investing in mutual funds. Small-company stocks are often traded infrequently, which means you may have trouble selling for the last price you've seen quoted. You're also taking on more risk: There's always the chance a stock price can go to zero.

The stock picks in the chart are by some of the best small-stock fund managers in the business. But these are just starting points, and you need to investigate the stocks carefully. Otherwise, your tuition to Stockpicking University could be costly indeed. If this all seems like too much work, consider investing in a good small-cap stock fund instead.

Fishing for low-priced stocks

Finding small stocks can be tricky. Here, five pros offer some of their favorites. P-E, or price-to-earnings ratio, is a stock's price divides by its earnings per share. Higher P-Es generally show investors are willing to spend more, in the expectation of higher rewards.

http://www.usatoday.com/money/wealth/making/mmw182.htm

Small Cap Stocks and Superior Returns

In 1981, Rolf Banz, a graduate student at the University of Chicago, investigated the returns on stocks using the database provided by the Center for Research in Security Prices (CRSP). He found that small stocks systematically outperformed large stocks, even after adjusting for risk as defined within the framework of the capital asset pricing model.

Some analysts maintain that the superior historical returns on small stocks are compensation for the higher transaction costs of acquiring or disposing of these securities. This means that there may be an extra return for illiquidity. Yet, for long-term investors who do not trade small stocks, transactions costs should not be of great importance. The reasons for the excessive returns to small stocks are difficult to explain from an efficient markets standpoint.

Although the historical return on small stocks has outpaced that of large stocks since 1926, the magnitude of the small stock premium has waxed and waned unpredictably over time.