KAREN GIBBS: Why do so many small and relatively unknown stocks outperform the bigger, popular blue chips? That question has baffled investors for years. This evening, Geoff and I will try and provide you with some answers.
Most fund managers are thrilled to gain double digit returns these days. But for Jim Oberweis, it's old hat. His Micro Cap fund has left the earth's atmosphere, soaring almost 60 percent so far this year, and up 16 percent over the past five years. Kevin Kennedy earned his stock-picking stripes in those infamous Internet chat rooms during the go-go '90s. Now he's editor of a top performing market newsletter: The Coolcat Explosive Small Cap Stock Report.
Gentlemen, welcome. It's great to have you. Jim, let me start with you, because many investors are turned off by the volatility of small cap stocks. But you have identified some stocks, some companies that make things that we know and use. Is that something that can ease and soothe investor worries?
JIM OBERWEIS: Maybe ease and soothe worries, but not necessarily reduce the volatility. The nature of the volatility for small cap stocks is really a factor of the company's size. The only way you could help to smooth out some of that volatility is to own a lot of different types of companies, and own small cap stocks as well as large cap stocks to help create an overall portfolio with moderate volatility.
GIBBS: Kevin, you're probably just the opposite, flying kind of without a net here and investing all over the world. What's the attraction?
KEVIN KENNEDY: In terms of small, I think I agree a little bit with what Jim's saying. A lot of the time what happens is these companies maybe were a high flyer two or three years ago, and then maybe they crashed during the Internet crash or the Nasdaq tech bubble and stuff. And so some of these stocks end up back down like in $2, $3 and stuff, and at some point they
stabilize and they've got a low market cap. And any kind of news or an improvement in their prospects will really make that stock move a lot more than say, you know, an IBM having an increase in sales. They're already such a big company that a smaller company with some big news can really act to boost that stock.
GEOFF COLVIN: Yeah, well let's get to specifics. Kevin, who do you like best right now?
KENNEDY: In terms of stocks, well, one of the things, again a lot of the Internet stocks had really been crumbled over the last couple of years, and they finally started to find a bottom maybe the middle of last year, towards the end of last year. And a lot of the Chinese Internet stocks have
already made a lot of move, and there's some stocks I think that are kind of a second tier of that same wave. Rediff.com, it's basically the Yahoo of India. Pacific Internet, it's another Asian Internet company. Sify, Gigamedia, Internet Gold -- they're all basically foreign Internet companies that are fairly small but are getting a lot of play.
COLVIN: Investors may be amazed to hear you recommending Internet stocks, and a lot of them have sworn to themselves never again. Do you think they're still good values?
KENNEDY: Well, I mean a lot of these stocks were $200, $300 a couple of years ago, and they get down to...
COLVIN: You get them for $1.
KENNEDY: They get down to $1, and basically they're survivors. And so a lot of those companies have been thinned out, and the ones that are left over, some of them have some very good growth stories.
COLVIN: Jim, who do you like best right now?
OBERWEIS: Sure. We're finding concentrated opportunities right now in technology and health care. We think that frankly in health care, those companies that will help ease the rising costs of health care, particularly given the demographics of the baby boomer aging population base, that's probably a good place to be. So in that area we like generic pharmaceutical companies, companies like Able Labs, the symbol ABRX, out of New Jersey. It's a specialty niche pharmaceutical company. We also like a company called Abaxis, ABAX, that makes a blood analyzer. Traditionally they marketed to veterinary doctors, and now they're actually importing it into hospitals. On the technology side, we like Omnivision Technologies, OVTI, that makes camera chips used in digital cell phones as well as in PDAs. We also like a British company that is the Expedia of Europe called Ebookers, EBKR.
GIBBS: Jim, you mentioned demographics. What other numbers do you look at when you decide to pick a stock?
OBERWEIS: Sure. When we're picking stocks, we try to identify companies that are in their early stages of growth that are trading at reasonable valuations. So we'll start with a company's sales, because that's a very difficult number for a company's management to manipulate. And we like to see companies that are exhibiting explosive sales growth from internally generated operations, a minimum rate of at least 30 percent. We also like to see a similar number in terms of earnings, and then we'll look at the valuation of the company to try to identify those best opportunities for companies in terms of P/E ratios, relative to a company's growth rate.
GIBBS: Kevin, it's very hard to get any information out of some emerging markets, particularly on stock picks. What do you look at?
KENNEDY: I'm not quite as interested in the fundamentals perhaps as Jim is. I mean I do look at them, but pretty much I'm looking for price and volume action.
I'm looking for a stock that's actually going up in price, typically making new highs, a big increase in volume. Because that kind of shows you that something's up. If you've got a stock that's real sleepy and all of a sudden, you know, a huge wave of volume comes into it, you know something's going on with that company. It may not always show up in the fundamentals right away, or maybe it's just a turnaround story. Maybe it's a first quarter of a situation. But typically low-float stocks, low market cap stocks, again for some of the reasons we were talking about before, have that opportunity to go up. And they've been replaced, the investors that sold on the way down have basically been replaced by a more patient investor. And then you get the momentum people that pile into these stocks when they see the volume.
COLVIN: They do have an opportunity to go up, but what you're talking about is what worries a lot of investors in small caps, which is they worry about these things being manipulated by other investors, because of course it can be done. They've read awful stories about it being done. And in fact when you see a big wave of volume or you see a lot of action, a lot of ordinary investors wonder if this is legitimate or something funny is going on. Now how do you protect yourself against that?
KENNEDY: Well, I think, you know, obviously you want to diversify. You don't want to have all your eggs in one basket. I really don't think anybody should have more than, say, 10 to 15 percent of their money in any one position. So I think that cushions you.
We like to look for stocks that have made a move and then pulled back maybe 25, 30 percent in price, because if you're going to have a stock that's going to go from, say, $2 to $20 or whatever, it's not going to go in a straight line. You know, maybe it's going to go to $2, to $8, pull back to $5, $5 to $10, you know, something like that. So when you do some buying on the pullbacks and diversify, I think that, you know, there's a lot of volatility as we discussed before, and you're never, you've got to basically have some selling rules also so when you're wrong, you get out.
COLVIN: Well, you do for sure, and that raises another thing, which, Jim, I wanted to ask you about, because you do a lot of trading and you can do a lot of trading in your fund. And a lot of investors have been advised for years and years, buy-and-hold is the way for most ordinary investors to go. Can that strategy work in small caps, or are they too volatile for it?
OBERWEIS: No. Actually I mean our average holding period for companies in which we invest is approximately two years. So we try to hit the high-growth stage of a company's life cycle.
And I want to go back to what you were talking about just a second ago when you were talking about the volatility and the potential for manipulation. We think that when stocks are improperly valued, it's a great scenario for us, because we think that we can identify a company and look at their fundamental businesses and come up with reasonably good estimates of what those businesses are really worth. Well, if the market is telling you that it's worth something
different, it gives you the opportunity to trade off that and potentially make a profit.
And that's exactly why we love small-cap stocks. Small-cap stocks aren't as efficiently priced. There might be three or four institutional investors, and it gives us the opportunity to jump in in a period of inefficiency and hopefully scalp a profit off of it.
GIBBS: Jim, doesn't that inefficiency then bring back that risk that we are so worried about, particularly when you look at the returns of say the Wilshire Micro-Cap, up 27 percent since say the beginning of the bear market.
OBERWEIS: There's always risk within small cap, but I think there's a distinction between risk and inefficient prices. I think there are certainly times in which stocks are inefficiently priced, and those are great opportunities. How can we possibly achieve a better return on Microsoft when there's 40 or 50 analysts chasing Bill Gates every day? Now if there's a company that not too many people have heard of and there's no other institutional investors, it's a lot easier to be smarter than the average guy. And that's the area we try and focus on.
COLVIN: Well, of course there is a lot more information available to investors over the past 15 years. It's been a revolution.
OBERWEIS: Absolutely.
COLVIN: Does that make it easier or harder to make money in small-cap stocks? Kevin?
KENNEDY: Well, I think, again, I really don't, I follow the volume a little bit more. I think, yeah, there may be more information on some of the larger caps and that may give people some comfort. But look at the Enrons, you know, the WorldComs. I mean those were huge companies and people thought they...
COLVIN: People still didn't figure them out.
KENNEDY: People thought they knew a lot about them, but they didn't.
COLVIN: They didn't. Jim?
OBERWEIS: I think that the information advantage over a long period of time should reduce the excess profits for small-cap stocks. The corollary to that, though, is that the small-cap market is still small. You still don't see large investment banks pouring money into that sector because they just can't buy enough issues to get the bang for their buck. So we still think that there's an inefficient marketplace, and small caps will probably lead the market over the next five, 10 years.
COLVIN: Thanks, Jim. Jim Oberweis, Kevin Kennedy, thanks for your views.
Mark Hulbert interview
KAREN GIBBS: Mark, thanks for joining us, you just heard from from our newsletter guys: the Oberweis report, as well as Coolcat. Tell me what you think of Oberweis.
MARK HULBERT: Oberweis, of the two, is the one that I have the longest track record for. That's important, because from a statistical point of view, you often need at least 10 years, if not more, to really start differentiating those whose good performance might be due to luck, versus those who have genuine ability. And we have 15, 16 years of data for the Oberweis report, which gives us a little more confidence about projecting how they would do in the future, rather than looking at a four or five year record for the Cool Cat report. Even though it's been an outstanding track record for four or five years, it's still not long enough to say much more from what the early precincts are reporting.
GIBBS Coolcat, even though it has a shorter record and a phenomenal return, they're on both sides of the market right?
HULBERT: The Oberweis report takes a much more long-term, buy-and-hold approach. Not to say that they don't trade in and out of individual stocks, but nevertheless they're going to be substantially invested in stocks for the duration, whereas the Cool Cat report is much more of an in-and-out trader, and will play both sides of the market. It'll be in cash, it'll be short, it'll be long again. It's a riskier game -- you have to be very nimble to catch each one of these short or intermediate rallies. Kevin Kennedy has done an excellent job for the last four or five years, but nonetheless with a relative short track record. Even though we think four or five years is a huge track record from a statistical point of view, unfortunately, we need a lot more.
GIBBS: Those are just two of the 160 newsletters that you track. Is there any consensus on where we're going and where the market is right now?
HULBERT: I'd have to say, "No." A lot of newsletters jumped on the bullish bandwagon in March and April, as the market rallied in the wake of the Iraqi conflict, but a lot of newsletters have pulled back since then.
We very carefully track the exposure to the markets that the newsletters are recommending, and it jumped from -20 right before the war started, to +65 very quickly after -- that's a huge jump in average exposure to the market among the newsletters we track.
It's now dropped back down into the teens, which is to say, slightly above the neutral range, but not a lot more bullish than the neutral range, which says though newsletters are saying things that are rather bullish or making bullish noises, in terms of what they're doing as opposed to what they're saying there's a lot of cautiousness out there among the newsletters we track.
GIBBS: You've done a lot of studies on small-cap funds and small caps' role in bull and bear markets. Can you tell me a little bit about that?
HULBERT: Well, we of course, look at what the newsletters are saying, and one of the perspectives newsletters are saying about small caps -- which I haven't seen made into the broad public debate about this bear or bull market, depending on your perspective -- is that in the first few months of a recovery off of a bear market low -- so at the beginnings of true, genuine bull markets -- typically the strongest sectors of the market are more the value sectors of the market, the companies that have solid asset bases, strong earnings, are trading at relatively low ratios for price-to-book value and so forth. We're not seeing it here. In fact, the stocks that are strongest in the rally since March have been the growth stocks, in particular, the small cap growth stocks sector.
A lot of the companies have been the strongest are those that have negative earnings -- they don't have very many assets at all, and rarely, if you look back in history, do you find that the first sectors of the market that have been strongest after a bear market low have been small-cap growth stocks. In fact, usually it's the bear market rallies that are the ones in which you see small-cap growth stocks, the more speculative sectors of the market, being strongest. Unfortunately, from that historical perspective then, you'd have to say that what we're seeing now is more likely to be a bear market rally than the beginning of a brand new bull market.
GIBBS: Mark, you've looked at the most popular stocks that have been recommended by the most successful newsletters, and those stocks are Findwhat.com, J-2 Global Communications and Merck. What does that tell us?
HULBERT: The newsletters -- not just now but over the last several months -- have very eagerly jumped on the bandwagon of the tech rally, the Internet rally and so forth, which has really led the market since the March lows. In fact, my list of most popular stocks is almost indistinguishable from the list of most popular stocks in late 1999, right before the Internet bubble broke.
Now, of course, it may be that this time is different, but nonetheless, I've got to think of a Rip Van Wrinkle who fell asleep three years ago and woke up today and said, "What's changed? The same set of stocks are the ones in which the newsletters, at least the ones that recommend individual stocks, are most excited about." Again, that's back to this notion of small-cap growth stocks -- are they the ones that lead a bull market at a beginning of a bull market? Rarely do they do so.
GIBBS:: It is a very persuasive argument. Now you do have some top bear market newsletter performers, interestingly enough: Investment Quality Trends; The Turnaround Letter; Vickers Weekly Insider Report and the No-Load Mutual Fund Selection. Why is it more important for newsletters to beat the market on the way down than on the way up?
HULBERT: I reached that conclusion by analyzing newsletters' long-term performances, and then looking to see the path they took to beating the market over the long term. And it turns out that only a minority of the newsletters that have beaten the market over that longer period of time beat the market when it was going up, but in contrast almost all of them beat the market when the market was declining. And that led me to the conclusion that it's far more important to beat the market when it's declining than when it's rising. In fact, most newsletters that beat the market long-term will end up being far more than willing to lag the market when it's going up, because they're looking at the risks of what happens when the market turns against them, and they know that it's far more important for them not to fall off a cliff when the market goes against them.
This goes against a lot of personal psychology. Most investors, even if they don't say quite in these words, will end up loving the thrill of victory, of beating the market when it's going up. And they love to talk about the latest IPO that's gone up 100 percent on the day of the offering and so forth. And to participate in those kinds of gains gives them huge thrills, and they're almost more willing to take those thrills along with the agony of defeat when the market goes against them, then to take a more "slow-and- steady wins the pace"
GIBBS:: And that brings us to the most popular funds recommended by the 10-year market beaters: Fidelity Capital Appreciation; Heartland Value; Vanguard Healthcare; and Vanguard Total Market Index. What's the common denominator with those funds?
HULBERT: What's interesting there is, those mutual funds are far more diversified, and if anything they have more of a value bent then the stocks that are most recommended. And so I find there's a striking contrast between the most popular stocks and the most popular mutual funds. Obviously the mutual fund newsletters are taking a far more conservative bet, and not going out for the sector mutual funds that are betting on telecom or technology or the Internet; they're going for a much more diversified bet, as opposed to the individual stock newsletters, which seemingly are jumping on that bandwagon of the tech and Internet rally since March.
GIBBS:: Mark Hulbert thanks for joining us.
Richard Sloan interview
Wall $treet Week with FORTUNE co-anchor Geoff Colvin recently interviewed Richard G. Sloan, director of the Financial Research and Trading Center at the University of Michigan Business School, and the university's Victor L. Bernard PricewaterhouseCoopers Collegiate Professor of Accounting and Finance. Sloan argues that one of the best ways for investors to evaluate publicly-traded companies is to look at their "quality of earnings." He basically says companies whose cash flow matches or exceeds reported income are more likely to be good buys than companies whose earnings are higher than cash flow.
Portions of the discussion were used on our Aug. 15 broadcast. Here is the complete interview, including parts that did not air:
GEOFF COLVIN: Professor Sloan, what have you found?
RICHARD SLOAN: About 12 years ago, I set out on a research project to put to the test some of the Graham and Dodd/Warren Buffett-type principles of value investing. And most of them worked reasonably well, but the real surprise was the quality of earnings strategy and they talk quantitatively about this in Warren Buffett's letter to shareholders and Graham and Dodd in their famous text, Security Analysis. And the trick was to come up with a measure where we could apply what they were talking about qualitatively. And once I came up with that measure, the returns were actually really staggering. I thought I'd made a mistake when I first saw the results come off the computer.
COLVIN: What results did you find?
SLOAN: We found hedge portfolio returns -- that's the difference between the returns on the best portfolio of stocks we could construct, and the returns on the worst portfolio of stocks we could construct -- were about 15 percent. And the various other strategies we looked at, you know, struggled to get anywhere close to say 5 percent.
COLVIN: Now when you look at quality of earnings, you are looking at essentially the difference between what a company reports when it reports its earnings, in the way it gets reported in the newspapers, the difference between that and the actual amount of cash that they are able to put in the bank. Right?
SLOAN: Exactly. It's a concept we call Free Cash Flow. So, what we are actually looking at is the amount of cash that the company is generating from its operating activities. They can use, they can put that cash in the bank, they can pay down debt, they can pay dividends. But it's the earnings relative to the cash that comes out of the operating activities.
COLVIN: And when you look at it, you look not at just free cash flow, people have been preaching that gospel for a long time, but you compare it to the size of the size of the company overall, and look to see how big that ratio is, yes?
SLOAN: Yes. It's a simple little metric. It's the difference between the earnings, the free cash flow, and we have to divide it all, by say the total assets of the company. So we can control the differences in the size of the companies.
COLVIN: And this enables you to spot good companies and also to spot trouble. Have you got some examples of that?
SLOAN: Sure, a good example that I can give you here, one that most people are probably familiar with, is WorldCom. And to tell you how this works: in the long run earnings and cash flows -- free cash flows -- have to be the same. All the accountants get to do is, in the earnings number, juggle the cash flows between periods. So what happened to WorldCom back in 2000 and 2001 was, the company took some of its cash costs -- they were called line-operating costs -- they had to pay cash to the telephone networks, for using their networks. And instead of charging them off against net income, they put them on the balance sheet as an asset. Now when you do that at some point in the future, all you have to do is take them to the income statement and once that (is done that) asset's no longer got any value.
So, what we saw during that 2000-2001 period was earnings going up and staying high, but we saw like a big dip in cash flows -- a big dip in the statements of cash flows. And that's how this strategy would have picked out a company like WorldCom in real time.
COLVIN: In other words, you're saying that your strategy would have said there was a problem here, even before we knew anything about scandals.
SLOAN: Exactly. Yeah, and there's a very simple metric. And if you go back and crunch the numbers on WorldCom -- we do this all the time with our students -- you'll see it pop out.
COLVIN: Now, a lot of people, a lot of companies, in fact, virtually every company, has a difference between the earnings they report and the amount of cash it actually has. Does that mean it's doing anything wrong?
SLOAN: No, exactly. This is the point, you know: we can't say with any certainty with an individual company that there's a problem. But what we can say is across a portfolio of companies, historically we've been pretty much guaranteed that you'll pick something up.
To give a sense of how it works here, let's say a company has very high earnings, but cash flows that's lower. In theory, what should happen here is the cash flows in the future should rise up to the earnings. What we actually find happens in practice, on average, for the typical company is, the earnings come down and the cash flows come up a bit and meet in the middle. But the analysts and investors don't see the earnings dip coming.
COLVIN: Using the screen that you've developed, what are some companies that look good to you now?
SLOAN: Well on the plus side, now remember that these are companies where cash flows are very high, relative to earnings. I'll give you a couple of examples. These are also companies that look like they are reasonably valued and are growing reasonably. Some of my favorites, one is called The Sportsman's Guide (SGDE). And this is a retailer of outdoor gear for people like hunters and the like. Now they've been around I think about 20 years primarily as a catalog business they started out. What they done successfully over the last couple years, the two, three years, is start an internet retailing business. And what happens here is they've been able to very, very successfully leverage their catalog business so they can increase sales through the internet without having to outlay a lot of extra cash and the infrastructure supports their sales.
COLVIN: Who else?
SLOAN: Another example would be Thomas Nelson. They're a publisher and they focus on family values, religious titles.
COLVIN: Biggest publisher of Bibles, if I'm not mistaken.
SLOAN: Exactly. Exactly. And they are running a very tight ship right now. You know, they just had their quietest quarter of the year and so not a lot of people were looking at them, but they came out with surprisingly good numbers for that particular quarter, it's normally their worst quarter. Now the quarter coming up is their best quarter. If they can turn in a comparable performance in the next quarter I think they'll do very nicely.
COLVIN: The companies you just mentioned, as well as most of the other companies, that I've seen in your work are small-caps. Is there a reason for that?
SLOAN: You know, we do find the strategy works better on the small caps. The primary reason is there's simply less analysts following them. Obviously the analysts aren't all out to lunch here, But these small cap stocks I'm talking about like The Sportsman's Guide, I think has about two analysts following it that are covered by First Call. I think Thomas Nelson has, maybe, one analyst. So you can see as an individual investor or as an analyst, you've got far more potential to find something because there's far fewer people looking.
COLVIN: In other words, the big companies might have a lot of analysts following them and they are more likely to be doing the kind of analysis you describe.
SLOAN: Right. There was actually one analyst on WorldCom. We see there was obviously a lot of analysts on their stock, one did pick it up. Just not enough other analysts and investors, I guess, listened.
COLVIN: Now, the record for your screen and for tools are very impressive. But of course, any method for picking stocks, if it works, should eventually cease to work because as people get on to it and more and more people do it. The opportunity for advantage disappears. Is something like that going to happen in this case?
SLOAN: I certainly think so. I mean there's plenty of people out there who have the advantage now. The other thing is, here I thought that -- I thought that (advantage of this method would disappear) about five years ago when I discovered this and published it. So, I never bothered to try and do anything with it myself. And (yet) it has actually worked very nicely since then.
We've been able to refine it some, too. So, you know, when I talk to the big institutions, they tell me, "Hey it's still working, and we're making the most of it while we can." But everyone expects it will go away sometime in the future, and my job here a professor is to try and make markets more efficient, not to try and make a quick buck for myself.
COLVIN: Well to help a little bit in that process, how can investors access this style of investing for themselves?
SLOAN: You know the specifics are sort of complicated. I actually have a book on the topic. But we have a couple of websites to help investors out that I run with the university students here, and the help of the university. They are free sites where we run these screens on some of the software and financial databases we have here.
If you are looking for buys, we have a site called valuedog.com, and this is where we screen, once a month, if companies look attractive on a cash-flow-to-earnings basis and also look to be reasonably valued.
If you are looking for stocks to avoid, or you are looking for stocks to short sell, if you are into short-selling, we have a Web site called earningstorpedo.com. And each month on that site we look for the 100 companies we view as most likely to have a quality-of-earnings problem in the near future.
So they're free services that we make available on a monthly basis and we've been doing that for a couple of years now and we've been monitoring their performance and they've done very nicely, so perhaps the last few years have been kind to us. But we do seem to have done very well.
COLVIN: It's fascinating research, Professor Richard Sloan. Thanks so much for being with us.
SLOAN: Thanks so much for having me on the show.
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