For five straight years small-cap stocks have outpaced their large-cap brethren. But the smallest of the small -- microcap stocks, with market capitalizations below $300 million -- have been on an absolute tear.
Last year the University of Chicago Graduate School of Business’s CRSP 9-10 index, the group of small-cap stocks composing the ninth and tenth deciles of New York Stock Exchange market capitalization, advanced 78 percent. That compares with a 47.3 percent advance in the Russell 2000 index of small-cap stocks and a 28.7 percent rise in the Standard & Poor’s 500 index. For the five years ended May 31, the CRSP 9-10 index climbed an average annual 17.3 percent, versus a 12.3 percent rise for the Russell 2000 and a 1.51 percent decline for the S&P 500. This year the returns have been equally strong -- during the first five months, the CRSP 9-10 and Russell 2000 indexes each rose 2.44 percent, while the S&P 500 was up 1.47 percent.
Microcaps began the five-year period relatively undervalued. As recently as the first quarter of 2003 -- after outperforming large caps for four consecutive years -- many microcap stocks were still trading below book value, says Denis Amato, manager of the $252 million Fifth Third Micro Cap Value Fund. The sector (roughly 5,000 stocks with a combined market cap of $275 billion, according to Prudential Equity Group) benefited from falling interest rates last year and, more recently, solid earnings gains.
But now interest rates are on the rise and valuations often seem pricey, causing many observers to wonder if microcaps can sustain their torrid pace.
“Microcaps are very interest rate sensitive and typically underperform when rates rise,” says Steven DeSanctis, director of small-stock research at Prudential Equity. Another sign that the microcap rally may soon end: The economic recovery has entered its second year. “Historically, small caps and microcaps have underperformed large-cap stocks in the second year of an economic rebound,” says DeSanctis.
Yet microcaps offer one decisive advantage that prevails in bull or bear markets: The sector attracts very little research coverage. Analysts follow perhaps 25 percent of the sector’s stocks, versus 92 percent for small caps. Since the research department cutbacks that followed the Wall Street research scandals and the arrival of the bear market, coverage is spottier than ever, which means there is a real opportunity for a smart stock picker to find an overlooked gem.
“This remains one sector of the market where active portfolio management can still generate a lot of excess return,” says Carl Wilk, manager of the two-year-old, $79 million Gartmore Micro Cap Equity Fund, up 94 percent in 2003 and 11.3 percent through early June.
Wilk favors stocks with market caps under $300 million that are growing earnings at an annual rate of 20 percent or more and selling at a 20 percent to 40 percent discount to their earnings growth rates. Wilk says his price discipline won’t allow him to buy a company unless its PEG ratio, (the ratio of its price-to-earnings multiple to its earnings growth rate) is less than 1. “If I expect a company will grow earnings at a 20 percent rate for the next several years, I want to buy its stock at a price-to-earnings ratio below 20,” Wilk explains. Companies must also have strong balance sheets, little debt and a return on equity of at least 10 percent.
Wilk keeps his fund’s positions small and prunes them when they exceed 2 percent of assets. “There’s a lot of potential for disappointment in microcaps,” he says. “One way to protect the fund is by not having too much money in any single stock.”
Among Wilk’s recent purchases is Diodes, based in Westlake Village, California. The manufacturer of specialty semiconductor chips used in consumer products has a market cap of $285 million. “This is a very well-managed company,” Wilk says, noting that it made money even in the economic downturn. And now that the economy has picked up, Wilk estimates its earnings will grow about 20 percent a year. He began to accumulate the position in June 2003 at an average cost of roughly $14 a share. The stock recently traded at $23, and Wilk has no plans to trim the position until it reaches $44. “The stock still has a long ways to go,” he says.
Another favorite is Lawrence Electronics, which has a market cap of $80 million and is based in Tulsa, Oklahoma. The company designs and makes sonar and global positioning system products and digital mapping systems for boating, general aviation and automotive navigation. The niche company doubled its earnings in 2003, and Wilk thinks profits could increase 60 percent this year. He began to buy the stock in the fourth quarter of 2003 at an average price of about $14. It recently traded at about $22 a share, and Wilk believes it could hit $60 in the next two years.
The portfolio manager is hanging on to Norval, Ontariobased SunOpta, a company that makes soy-milk concentrates and oat fibers that are used in the manufacture of trendy low-carb food products. It has a market cap of $407 million, higher than his usual target. “SunOpta is the largest supplier of oat fiber to the food industry,” says Wilk. “It has a big leg up in the growing low-carb market.”
Amato’s Fifth Third Micro Cap Value Fund has delivered a 20.5 percent average annual return over the five years ended March 2004 in part by focusing on the stock sales and purchases of insiders. “In the case of very small companies, managers know what they are worth,” says Amato. “If insiders are buying, it’s a sign that they know the company is worth a lot more; they may even have had offers to sell the company to a private buyer.” Amato also pays close attention to balance-sheet strength. “Small- and medium-cap companies can’t go to the bank like General Motors whenever they need funding,” he says. “So it’s important that they have the cash to work out any problems.”
Like many microcap managers, Amato manages risk through careful diversification. The fund typically owns more than 100 issues.
One of Amato’s recent hits is ArthroCare Corp., a maker of electrosurgical tools used to remove soft tissue in arthroscopic surgery procedures. He began buying the stock in late 2002, when it was selling at about $10 a share, or a little less than two times book value -- the low end of its historical price range. ArthroCare had no long- or short-term debt, little goodwill and $45 million in cash. The stock price dipped when the company announced it was taking a $2.7 million charge to earnings, largely reflecting an inventory revaluation driven by the transfer of production from Sunnyvale, California, to lower-cost facilities in Costa Rica. “It was a positive event going forward, but we had to adjust our historical cost structure,” explains Fernando Sanchez, ArthroCare’s chief financial officer.
In addition, there was significant insider buying. When the stock reached about $20 a share -- roughly four times book value -- and insiders began to sell in late 2003, Amato unloaded his position -- a little early, it seems. The stock recently traded at $26.56.
John McCraw, lead portfolio manager of the $80 million Nicholas-Applegate U.S. Mini Cap Growth Fund, which returned an average annual 13.9 percent over the five years ended June 4, looks for strong earnings momentum that is not yet reflected in a stock’s price. “An acceleration in the earnings growth rate pushes the stock price up as earnings increase and the P/E multiple expands,” says McCraw. He doesn’t set absolute growth rate targets. “We don’t need to see 15 to 20 percent growth. We simply are looking for a growth rate that is higher than the previous year’s,” McCraw says, noting that on average the fund’s companies are growing earnings at about 40 percent a year.
Last year the fund gained 83.9 percent. EResearchTechnology, a leading provider of technology used by pharmaceuticals and biotechnology companies to collect, interpret and distribute cardiac safety data for clinical trials, was one of its best performers. The Philadelphia-based company’s stock jumped more than 400 percent in 2003.
McCraw began to accumulate his position in 2002 when the shares were selling at about $7. Soon after, the company benefited from a Food and Drug Administration ruling that mandated an increase in required data for cardiology drug trials, a decision that was almost certain to boost EResearchTechnology’s revenues. The fund still owns the stock, which is trading at about $20.
Recently, McCraw loaded his plate with Buffalo Wild Wings, a Minneapolis-based restaurant chain that has been growing earnings at a 30 percent annual clip since it opened for business six years ago. McCraw bought the stock during the November 2003 IPO at an average cost of about $20 a share. It recently traded at about $28 a share, but McCraw isn’t clearing the table quite yet. He figures the company, with 220 restaurants in 28 states, can find plenty of room to grow.
Buffalo Wild Wings may take off. But with the economic recovery now in its second year and interest rates about to rise, the company’s shares could be flying into a head wind.
