Investment Insider: Jim Weiss on small-cap stocks

October 22, 2001

They&ve languished for years, but we talked with an expert who expects they'll lead the market before long.

 

Investment Insider

Jim Weiss on small-cap stocks

They've languished for years. But here's an expert who expects they'll lead the market before long.

There was a time when small-cap stocks were supposed to power your portfolio. Because of their size—typically, $250 million to $3 billion in capitalization—any new revenues had a much bigger percentage impact on earnings than they would with a larger company. Also, a new product is more important to the smaller company, which is working off a smaller base of existing business.

From 1991 to 1993, small businesses were indeed heroes, with annual returns that averaged 27.2 percent, compared with 15.6 percent for the Standard and Poor's 500 Stock Index. Then, small companies faded to the background, and mostly trailed the S&P 500—until recently. For the 12 months through last August, the Russell 2000 Index, which represents small-caps, returned ­11.6 percent, while the S&P 500 lost 24.4 percentage points. The reversal may herald a small-cap revival.

To explore that possibility and discuss the role of these stocks in your portfolio, Medical Economics Senior Editor Leslie Kane spoke with Jim Weiss, chief investment officer—equities, at State Street Research in Boston, an investment firm that manages $49 billion. Weiss, who joined State Street in 1995, oversees the firm's nine equity portfolios, including the small-cap Aurora Fund, which beat the S&P 500 by about 44 percentage points for the 12-month period through July of this year.

Previously chief investment officer at IDS Equity Advisors, Weiss also spent a large part of his career in portfolio management with Stein Roe & Farnham. The 55-year-old Certified Financial Analyst earned a BA from Marquette University and an MBA from The Wharton School of the University of Pennsylvania.

When will small-caps again lead the market? Possibly by mid-2002. I think we're heading into a favorable environment for small businesses. Low interest rates and a general feeling that the economic slowdown is ending are positive signs. The prime interest rate is now 6.0 percent, compared with 8.5 last February. And other sources of money have opened to small companies, which means these companies can more cheaply and easily get money for expansion and operations. Also, as interest rates decline, the IPO market opens up again, which enables new companies to start developing. Since they're at the start of their growth cycle, they have an excellent opportunity to grow their earnings per share.

Why did earnings growth rates for small-caps lag behind the growth rates of large-caps toward the mid-'90s? Rising interest rates made it harder for small companies to get money. In addition, a disproportionate number of small companies are cyclical, with sales and profits tied to the economy. Economists began forecasting an end to the expansionary economic cycle. Thus, the fear of recession—as opposed to an actual recession—was impacting the market. Companies in the building industries, small retailers, and small restaurant chains, for example, do better when the economy is moving ahead—unlike large drug and beverage companies, say, whose fortunes are not so tied to the economy's ups and downs.

Earnings growth rates for small-cap companies actually fell behind the growth rate for larger companies. Investor preference for blue-chip companies was another factor. Investors headed for large-caps, and stock prices reflected that preference.

What makes you choose a company for your portfolio? First, it has to have great products and a strong balance sheet. We want to be excited by the company's research and development and its plans for expansion or new products.

Good management is also a key criterion. By that, I mean an executive team with experience and success in that specific industry, a team that has run a similar type and size of company through good and bad periods. Leaders who can take advantage of positive surprises and defend the company against adversity make a big difference.

Here's an example: In January, with a slowdown in travel underway, Hotel Reservations Network (ROOM-Nasdaq), a consolidator of hotel and lodging accommodations, started negotiating to take more rooms from the hotels. This helps the hotels, but, more important, improves ROOM's revenue and cash-flow growth, and expands margins. In addition, ROOM will benefit from its larger market share once travel increases again.

What else do you look for? A potential catalyst—some future event that will excite the market. A business can have good products, but the stock goes nowhere. We want to see a possible trigger, such as product approval by an agency, that will get the stock noticed and make investors think more favorably of the company. In the case of ROOM, its rapid growth, and the fact that almost all incremental business converts to cash flow, will show investors that there are still profitable businesses developing on the Internet.

Finally, the stock has to be selling at good value. People will no longer go for stocks with overly high price-to-earnings ratios. Investors were burned in the recent market decline, and they're not likely to buy at such inflated prices.

How long do you wait for a company's share price to rise? We measure by events, not by time. We'll keep a stock as long as the business fundamentals remain intact and the company fulfills its promises—such as growing earnings 20 percent annually, or introducing three products a year. Or we might retain the stock until it hits our price target.

And we're not rigid; if a stock reaches our target price, but we see further potential, we may keep it. We've held stocks as long as five years. However, if the company fundamentals deteriorate, or its plans don't materialize, or we find that its executives misled us, we'll re-evaluate and probably sell.

Can you name some small-cap companies that will shine over the next few years? We like JLG Industries (JLG-NYSE). It's the world's leading manufacturer of mobile aerial work platforms, telescopic material handlers, and hydraulic excavators, some of which are used for work high above the ground—such as boom lifts, which reach up and over other equipment. JLG Industries' equipment is more flexible, more productive, and safer than its competitors', which gives JLG an edge.

The company's earnings have been down this year because its customers held back on purchases as the industrial recession spread. But we expect earnings to rebound in 2002, especially since international sales are picking up. Current share price is around 10, and we're targeting over 18 by next summer. The catalyst is that JLG Industries will be one of the few industrial-type equipment companies that generated earnings in these difficult economic times. Investors will learn about this, and that will enhance the stock price.

We're also hopeful about AdvancePCS (ADVP-Nasdaq), a fast-growing pharmacy fulfillment and distribution company. AdvancePCS provides services for delivery of drugs through mail-order and online pharmacies, and serves more than 75 million Americans. Earnings per share are expected to grow 60 percent this year and 40 percent next year. On its side, Advance-PCS has the trend toward increased mail-order drug fulfillment and the growing drug needs of an aging population. Share price, now around 65, should hit 80 in a year.

How much should investors keep in small-cap stocks, and what time horizon is appropriate? Because they're relatively volatile and risky, small-caps shouldn't be a core asset in a portfolio. If you're young and have a stable income, you could put 20 to 25 percent of your portfolio into small-caps. If you're close to retirement, you'll need the money for an upcoming purchase, or your income is declining, small-caps should be no more than 10 percent of your investments.

But at any age, consider your temperament. If prolonged negative returns or a temporary downturn will get you terribly upset, stay away from small-caps.

 

Leslie Kane. Investment Insider: Jim Weiss on small-cap stocks. Medical Economics 2001;20:38.

Related Content:

Money