Small-cap investing embodies risk, reward
Theoretically, investors can find big returns from small companies, but the dangers are just as great.
By Larry Dignan
August 14, 2003
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The quintessential small-cap fantasy goes like this: Our Investing Hero finds an undiscovered company with strong earnings and sales prospects; buying shares early, this shareholder hangs through all doubts and naysayers, and eventually Wall Street analysts, the media and other investors hop aboard the bandwagon. The company's market value skyrockets. Our Hero rolls in a sea of profits.
It's a vision many small cap investors have, and for good reason. The market for smaller companies is inefficient, and theoretically, you could find a company that may become the next Microsoft. Many money managers say investors should allocate part of their portfolio to small caps to deliver growth. Simply, put you have a better chance of hitting a home run with a smaller company than a large one.
Historically, smaller companies deliver bigger and better returns than their larger brethren, a trend that has held up this year: The Russell 2000, a proxy index for small-caps, has risen 22 percent since the end of 2002, compared to a 12 percent return for the S&P 500. Morningstar's small cap index has done even better, up more than 24 percent.
So what's not to love?
For starters, the risk. Big returns usually require bigger risks. Smaller companies are less liquid, harder to follow and easier to manipulate. Many institutions won't touch these stocks because they couldn't acquire a position quietly.
Investors that don't relish doing their own research, screening stocks and reading filings with the Securities and Exchange Commission need not apply, although people who dislike fishing for stocks can invest in small cap mutual funds or buy an exchange traded fund tracking an index like the Russell 2000.
"You've got to do the homework," says Chris Orndorff, a portfolio manager with money management firm Payden & Rygel. "Small caps are not 'lazy man' stocks. An individual can level the player field (compared to large investors) and find an undiscovered value, but it takes work."
Small-cap portfolio manager John Piccard says individual investors, armed with stock screening tools from sites like Yahoo Finance and Morningstar, can find good companies before others. But Piccard, of JPMorgan Fleming,notes that big bets should limited to a small portion of a portfolio.
Before hopping into the small cap market, it makes sense to define the universe of stocks you want to track.
A solid definition of what makes a small cap is hard to come by. Some portfolio managers define a small cap company as one with a market capitalization of less than $3 billion. Others say small caps are companies worth between of $250 million to $1.5 billion. The Russell 2000 itself, which consists of the 2000 smallest companies in the investment firm's broad market index, has market values ranging from $116 million to $1.2 billion. The S&P 600 Small Cap Index generally consists of companies worth $200 million to $900 million.
In Piccard's portfolio, small cap companies can be valued as high as $2 billion to $3 billion. That lets him hold a stock that may have appreciated significantly in value.
Piccard is wary of stocks that trade below $5 and companies near "break points" that may have increased annual revenue to $500 million-to-$1 billion range. Companies that have grown to that level may need a deeper management bench or infrastructure investment to continue growing.
Generally speaking, below $250 million constitutes a 'micro-cap,' which market watchers view the equivalent of as public venture capital.
Joe Dancy, who manages the LSGI Technology Venture Fund, says his favorite companies to follow have market caps of less than $100 million. He actively seeks companies that don't have analyst coverage and are largely unknown.
Dancy screens his own stocks and talks to management before making a decision. He says he looks for profitable companies with price-to-sales ratios of two or less. Earnings growth is important to Dancy, but it's not the number one metric since "sales can be manipulated less than earnings."
"Among the companies with market caps below $50 million, the returns can be stunning," says Dancy, who says he prefers to find companies with good growth prospects at a reasonable price.
Dancy says you need at a basket of at least 25 to 35 stocks to be diversified. You may hit a home run, but also prepare to strike out. Dancy tries to minimize risk by targeting companies that have positive cash flow and can fund themselves.
His fund has a median market cap of $32 million compared to $77 billion for the S&P 500. Among some of the names Dancy has listed in his newsletter: healthcare and medical companies such as Trinity Biotechnology, innovative companies, and Able Laboratories and energy players like pioneer Drilling and Natural Gas Services.
Meanwhile, Orndorff chooses to play upstream a bit. An example of a "safe" small cap is Medical Action Industries, a company that consistently grows earnings. Medical Action makes disposable surgical goods and items like sponges. "We look at companies that have pretty stable earnings and are focusing on a growing niche," he says.
He also likes Group 1 Automotive, which operates a chain of auto dealerships in the south, and United Surgical Partners, a company that runs ambulatory surgical centers. Both of these companies have market caps above $500 million but below $1 billion, and they do have sell-side analysts covering them.
Some of the appeal of small caps is their lack of overhead. Many small cap companies feature a flat management structure and less bureaucracy, so more revenue flows to the bottom line.
Steve Dilbone, a portfolio manager for the Victory Small Company Opportunity Fund, is on the lookout for companies that have high potential for growth, but are out of favor. The key for Dilbone is balance: he wants growth at a reasonable price. One of biggest challenges is finding a stock that Victory can invest in quietly. He looks for companies that can handle the trading volume and let Victory to build a position without moving the stock significantly.
However, finding those companies can be difficult. Dilbone says his universe of stocks is the Russell 2000 index, which rebalances every June and can jettison as many as 500 stocks or so.
"Every time it is rebalanced you have to learn hundreds of companies," says Dilbone, who tries to have about 90 stocks in a portfolio. "There are so many that it's almost impossible to track."
It takes a team of analysts to help JPMorgan Fleming's Piccard separate winners from losers. Unlike his peers, Piccard says analyst coverage of a small-cap stock isn't bad. Coverage on Wall Street can help get a company's story out and provide a catalyst for future moves. Analysts also provide a double check -- someone else finds the stock interesting for some reason.
Some of Piccard's favorites include Pier One Imports, Maxtor and Linens and Things.
Piccard says he's on the hunt for "growth at a reasonable price." Investors should value small caps as they would if they were buying the business for themselves, he says.
Figure out which future gems happen to be small and which companies deserve to be that way. "The good quality companies that are undervalued with growth prospects will bubble up," Piccard says. "But you have to find the ones that have potential and not the ones that deserve to be little."
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