Little stocks that rock
No rally lasts forever, but small caps have beaten the broader market since 2000. Meet a few that may keep up the streak.
by John J. Curran, FSB Magazine

(FORTUNE Small Business Magazine) - Call it the rally that wouldn't quite. After nearly six years of spiffy performance, small-cap stocks headed into 2005 facing a wave of dire predictions. The widespread view of market seers: Small-cap prices were too rich, the Johnny-come-lately fans too many, the bargains too few.

Yet small caps sailed through 2005, besting their larger-cap peers by a wide margin. For the 12 months ended May 1, 2006, the Russell 2000 index of small-cap stocks returned 31.5%, compared with 14.4% for the Standard & Poor's 500 index of large-company stocks.

FORTUNE Small Business: 50 Small-cap stocks to watch
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The longer view is even more impressive: Since March 2000 (the official start of this rally, when small caps bottomed out relative to their large-cap peers), the Russell 2000 index has posted an average annual return of 7.3%, vs. -0.6% for the S&P 500.

Why? Analysts point to the superior earnings growth of the smaller companies and to their allure as takeover targets.

Yet even as small-cap fund managers count their gains, they are voicing cautions. Observes John Montgomery of Bridgeway Capital Management, where he co-manages ten funds with assets totaling $2.7 billion: "As a group, value in small caps is much harder to come by." Take those as words from one who knows a good value. Among the ten money managers polled by FSB at this time last year, Montgomery stole the show: His five stock picks rose, on average, 103% over the 12 months, soundly defeating the Russell 2000. (In the aggregate, the 50 companies our managers recommended last year returned 46.7%.)

Too late to jump in?

But the success of small-cap mutual funds has a price. Since the beginning of 2005, more than 30 such funds have closed their doors to new investors, bringing the total number of shuttered small-cap offerings to 103 out of a total of 597 funds, according to Morningstar. And small-cap stocks are becoming expensive - the average price/earnings ratio for the Russell 2000 index is about 28, compared with 18 for the S&P 500.

Take heart, though. The fund managers featured here may see fewer great investing opportunities, but they say they're still finding winners. Consider Coinstar (Research), the Bellevue, Wash., company that is transforming the "fourth wall" in supermarkets (i.e., the storefront) into a profit center. Its big innovation, introduced in the 1990s, is the familiar green coin-counting machine, typically situated close to the exit, that gobbles up your jar of pennies and returns cash, minus Coinstar's 8.9% cut. The company has already placed 13,000 of these machines in supermarkets across the U.S., often joined by Coinstar's other cash cows, the popular gumball machine - "Mommy, Mommy!" - and kiddie rides.

Says David Kelley, portfolio manager at RS Investments: "The coin counters cost about $12,000 installed, but then generate $6,000 of cash flow per year." The stock recently traded around $26 (at a relatively rich P/E of 32, compared with 16 for the S&P 500), but Kelley says the company will probably get a boost from a recent deal to put coin counters in Wal-Mart. He expects to see more than 20,000 installed by the end of the decade and figures the stock will be comfortably in the 40s by then.

Another promising pick: Landec (Research) of Menlo Park, Calif. The company has 17 patents related to a synthetic polymer that "thinks" - that is, the material can respond to changes in temperature by changing its viscosity or permeability. Seeds that are coated with the polymer and then planted won't absorb water if it is below a certain temperature (which can damage the seeds) but will absorb that same water once it warms up.

On the consumer side, Landec has a similar product that can extend the shelf life of produce. A polymer bag it created regulates the oxygen and carbon dioxide levels within a package to maintain the optimum atmosphere. Result? A banana that stays ripe for as long as 12 days, compared with the normal two or three. The company recently inked a deal with Chiquita (Research) to package bananas for convenience stores and, reportedly, Starbucks (Research). "As this technology catches on, it could impact earnings in a big way in 2008 and 2009," says Michael Corbitt of Perritt Asset Management. That could put the $8 stock in the mid-20s.

In the hot seat

If a fund manager told you he was hunting for little growth companies in or around Detroit these days, you might question his sanity. But consider how many times you've suffered through your commute in a freezing - or searingly hot - car seat. Amerigon (Research), based in Dearborn, Mich., has the answer: Its patented technology provides climate-controlled car seats (which can be heated or cooled via a small electric motor) for a wide range of automakers, including Ford (Research), Hyundai, and Toyota.

While Amerigon has sold the seats since 2000, "the growth rate is starting to take off," says George Henning, a fund manager at Pacific Advisors. The P/E multiple is a steep 40, but Henning says to put on your seatbelt, because this stock is turbocharged. "Consumers love the product, and the company has no real competition," he says. He thinks the $7 stock could reach $10 in the next year.

Technical indicators

In an era of rich stock prices, compelling opportunities often lie where others fear to tread. Worries over higher interest rates, rising fuel prices, a housing slump - you name it - can hang heavy on a stock.

But the 15 stock-picking models employed at Bridgeway Capital don't fall prey to emotional swings or scary headlines. Instead, they coldly assess a stock's prospects based on such drivers as earnings momentum and valuation. Lately the models are flashing a buy on pipemaker PW Eagle (PWEI) of Eugene, Ore., which supplies those familiar white-plastic PVC pipes for sewage, water, even telecom cables. It's a commodity business, but the hurricanes of 2005 have sent prices soaring.

"You drag shareholders through years of red ink [PW Eagle lost money in four of the past five years], then report a profit, and investors are skeptical that you can sustain it," says Bridgeway's Montgomery. "But our models don't care," Reflecting investor skepticism, the stock carries a P/E of just 7.4. Another positive factor not included in Bridgeway's screens: In April the company announced that it would allow activist investors to join its board. Maybe Montgomery will have a winner even earlier than his models suggest.


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