Small-Caps Aren't Over Not all of them, anyway. Here's what six top small-company stock pickers are betting on now
(MONEY Magazine) – It's been an amazing run for small-company stocks. Over the past five years, the Russell 2000 index of small-cap stocks has beaten the large-cap S&P 500 by 40 percentage points. Many market watchers think small-caps will slow down, especially if interest rates rise. Last month, in fact, MONEY recommended moving assets into blue chips.
But unless you think you can time the market exactly--and good luck with that--small-caps always have a role in a diversified portfolio. (Small-caps are roughly defined as stocks with capitalizations, or outstanding shares times price, of $1.5 billion or less.) Since small-caps can sometimes rise when large-caps fall, and vice versa, having a bit of both can reduce your overall risk. What's more, thousands of small-cap stocks are out there. So regardless of what the index is doing, there are always opportunities. With that in mind, we asked some top fund managers how they've responded to small companies' lofty prices. They offered three key pieces of advice.
1. Think (just a bit) bigger
If any part of the small-cap world is overheated, it's microcaps. Companies with a market value of less than $500 million currently trade for 36 times the previous 12 months' earnings vs. a P/E of 30 for those with a value of $500 million to $1.5 billion. That means the bigger small-caps offer a better value. Already, says Michael Fasciano of NEUBERGER BERMAN FASCIANO, "the market is migrating toward higher-quality small-cap names."
Fasciano likes the $758 million DIRECT GENERAL (DRCT), an auto insurer that specializes in high-risk customers. It has a stronghold in Florida and is expanding rapidly into Texas. Fasciano reckons the company can boost earnings by 25% in both 2004 and 2005. Priced at just 11 times 2005 earnings, the company is cheap for that kind of growth.
Jack Laporte of T. ROWE PRICE NEW HORIZONS is edging up even higher in market cap, holding on to companies that have grown into midcaps. "The valuations are just more reasonable," he says. Among his favorites: $4 billion OMNICARE (OCR), a drug distributor for nursing homes. Concerns that new Medicare legislation could curtail growth have hampered the stock, so it trades for 18 times prior 12 months' earnings vs. its historical average of 31. But after a decade-long acquisition binge, the company is cutting costs and using its size to negotiate better deals with drug companies.
2. Check out a few laggards
Bargain-conscious investors can always find plenty of unfairly ignored names among small-caps. T. Rowe's Laporte is digging through the consumer sector right now--it's been particularly hard hit by interest-rate worries and rising gas prices (which pinch consumers' wallets). Take the $1.8 billion ANN TAYLOR (ANN). In early May the women's clothing retailer reported monthly same-store sales growth of 9.6%, beating expectations by nearly four percentage points. But despite boosting its earnings outlook for the year, the stock has barely budged. At a recent price of $40, the stock trades for 15 times 2004 earnings--cheaper than the S&P 500 and the Russell 2000.
Bill McVail of TURNER SMALL CAP GROWTH has been buying more RARE HOSPITALITY INTERNATIONAL (RARE), which owns 245 restaurants across the country, including the Bugaboo Creek Steak House chain. The recovery in the economy means the $914 million company can get more midweek business and will be able to increase prices--translating into earnings growth of 17% going forward, says McVail. At $27, the company is trading at 18 times 2004 earnings.
Vince Gallagher of NEEDHAM SMALL CAP GROWTH is picking through the technology sector now. The group's fast-paced growth and overheated valuations make it especially susceptible to wild price gyrations. Gallagher likes midcap GARMIN (GRMN), which makes Global Positioning Systems. The $3.2 billion company has fallen to $29 from a high of $59 this year, in part over concerns that it won't be able to maintain its high gross margins. But even though Garmin may feel some pressure, Gallagher thinks its strong product lineup means its margins will remain the highest among its peers.
3. Invest globally
European small-caps sell for 11.9 times 2005 earnings vs. 12.8 for the big guys. They're also cheaper than U.S. small-caps. That disconnect has Chuck McQuaid of COLUMBIA ACORN amping up his exposure to foreign markets. The fund, which is predominantly focused on U.S. companies, currently has about 15% in foreign small-caps like health-care company GAMBRO in Sweden.
Of course, it's tough for individuals to invest directly in most foreign small-caps. So if you want a pure play on international shares, check out WASATCH INTERNATIONAL GROWTH fund. Manager Michael Gerding favors companies that are growing faster than both their industry peers and companies in their home country. One example: German shoemaker PUMA. Gerding racked up impressive gains in the 1990s at Founders Asset Management and has outpaced similar foreign funds by more than seven percentage points since the Wasatch fund's inception in 2002, according to Morningstar. --ADRIENNE CARTER