When Wall Street Scorns Good Companies These firms have great earnings, but their stocks are in the dumps. To find out why, you should look first at their management.
By Geoffrey Colvin

(FORTUNE Magazine) – The stock market is full of mysteries, especially lately, but here's one you might have missed: Though stocks overall are priced at such lofty altitudes you need supplemental oxygen to understand them, dozens of top-performing companies are selling at pitiable prices. Not ephemeral dot-coms, these are companies with actual earnings that have been growing at double- or even triple-digit rates for years. Yet Wall Street treats them with contempt, pricing them at derisory single-digit multiples--five, six, seven. This when the average stock in the S&P 500 trades at a mind-blowing 30 times earnings.

The mystery of the scorned is troubling to anyone trying to figure out the market--about all of us. How could the world's most powerful value-seeking institution behave so strangely? My guess: Many of the despised companies, odd as it sounds, are getting just what they want--so investors beware.

The companies we're talking about are mostly not ones you hear of. (Who's buzzing about stocks trading at five times earnings?) For a fascinating list of some of them--including such memorable names as American Biltrite and Arkansas Best--check out a recent report from U.S. Bancorp Piper Jaffray's Chicago office called "Endangered Species Update." Michael R. Murphy and Mark Buckley ran a few simple screens and identified 48 companies whose earnings before interest and taxes have grown at least 10% a year for five years and are trading at a maximum of 6.1 times those earnings. They're small--market caps of $50 million to $250 million. On average the group is even more anomalous than the criteria suggest. Overall their earnings have grown a stunning 44% annually for the past five years, yet they're priced at a measly multiple of 4.6. Superperformers selling for next to nothing. The Piper Jaffray folks call them Darwin's Darlings, since they're virtually begging to be eaten.

The conventional explanation is that the outfits are too small to get the Street's attention. Institutions, which own most equities, need to make big moves and so want big stocks with high trading volume. Yes, they make exceptions for high-glamour Net startups, but these companies are anything but: They're in gaskets, metal doors, plywood, things like that. For investors, standout performance doesn't outweigh the bother of owning them.

But that reasoning doesn't quite work. The Magellan fund may not have time for small caps, but someone ought to, such as a strategic buyer with a higher multiple. So why are all these firms still independent? The answer may lie in another fact about them: On average, insiders own half their shares. When the proportion is that high, the insiders are most likely founders; they have enough stock to fend off any hostile approach, and they haven't sold because they aren't ready to give up control. Not many outside investors want to go along for that ride. Thus, low prices.

But there's still a logical problem. Since the companies are so cheap, why don't managers buy the shares they don't already own-- take the company private at today's crummy multiple, then sell the whole shebang at an almost guaranteed higher price? Going private has in fact become more popular than ever, but what seems most striking is how rare it remains. Of Piper Jaffray's 1999 Darwin's Darlings-- 110 companies--only three went private in the following 12 months. That makes perfect sense if you figure that many of the outfits are run by owner-managers whose top priority is keeping control. Announce a going-private transaction and you put the company in play, and even a chummy board may feel obliged to honor its fiduciary duty if a higher bid comes along.

Thus we reach the somewhat ugly truth about Wall Street's orphaned stars: Many of them (not all) like things the way they are--that is, they like staying in control. The outsider owners are typically a diffuse bunch in no position to put heat on the controlling insiders. The stock price may be lousy, but when the owner-managers decide to sell--that is, to get out of the way--it will almost certainly rise handsomely, as it did for the 19 of last year's Darwin's Darlings that have since sold.

So shed no tears for these scorned companies, and don't buy their shares without a deep understanding of what the majority owners have in mind. In theory the spreading corporate governance movement ought to protect you; in practice the shareholder activists have bigger fish to fry. Such circumstances may keep share prices down, but that's the owner-managers' problem. At least, in this case, the market isn't so mysterious after all.