Small Caps: Growing Value And Valuing Growth

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.