Caution On Small-Cap Stocks

Despite a recent stumble, small-caps remain a popular, contrarian pick. Their smaller price tags enable investors to inexpensively compile a diverse portfolio.

June 1 1992 by Merry Sheils


Like the hemlines of fashion, so go the fortunes of Wall Street, up and down on a whim. This bull-market fad seems to be small-cap stocks: Record 1991 returns have attracted investors in droves.

But caution may be the watchword. After reaching a high of 644.92 on Feb. 12, the Nasdaq composite index-which consists largely of smaller stocks-has dipped 13.1 percent, while indexes that track blue-chip stocks have remained flat.

Just what is a small cap? The moniker means small capitalization, that is, companies with total capitalization (total debt outstanding plus total equity invested) of $500 million or less. Their price per share-frequently $15 or lower-enables both small and large investors to buy round lots of several companies, thus inexpensively diversifying their investment.

But small caps have many other attractive characteristics. Earnings per share can grow at a faster rate than that of larger companies. The reason: Devoid of layers of corporate bureaucracy, management can respond quickly to changing market conditions.

PACING THE PACK

In addition, as the U.S. economy emerges from a recession, increased order flows produce profits faster for the small company, says Gerald Perritt, manager of the Perritt Capital Growth fund.

He also notes that positive small-cap performance comes in streaks. When they outperform large companies-as they did in 1991 -they tend to do so for several years running. One study to which Perritt refers showed an average annual gain of 33 percent for small caps following the end of each recession since 1947.

The current decline in interest rates also may bode well for small caps. A large company has the ability to finance more of its growth through issuing long-term bonds. Small caps are forced to rely on bank debt, including short-term loans with less favorable rates than the prime lending rates available to large companies. When interest rates dip, funds previously allocated for bank debt repayment fall to the bottom line.

But small is not always better. Just as small caps outperform large companies in cycles, they also underperform them for equally lengthy periods. The reasons are varied. Small caps are oftentimes burdened with debt and are generally young. Moreover-at least during the first few years-they are usually unprofitable. A thin layer of management has its drawbacks, namely, a lack of seasoned experience needed to make good decisions during times of crisis.

A small company tends to function in a reactive mode as it scrambles to build market share against the giant shadow of fierce competition. In short, it has a tougher row to hoe. It cannot readily obtain credit from suppliers without substantial up-front costs.

To boot, small caps often don’t control their markets. Procter & Gamble, for example, virtually has a lock on premium quality toilet tissue through its leading Charmin brand. The small-cap company that manufactures a private label brand may be forced to lower its price to meet that of its competition. This could put added pressure on already thin margins.

TAKING ON BIG BLUE

A case in point: ITEL, a flourishing financial services firm in the 1970s, developed a prime market niche in financing computer peripheral equipment, namely, memory and disk drives. It relied on IBM to furnish the central processing units.

Buttressed by success and basking in hubris, ITEL began to encroach on IBM’s turf. It cloned Big Blue’s central processing units through a third-party foreign manufacturer-thereby going head to head with its competitor. Despite a clear warning from IBM, ITEL persisted, and IBM retaliated by announcing a price reduction in its mainframes. ITEL, which had contracted with foreign manufacturers to produce IBM clones, did not control its own manufacturing costs, and therefore its pricing structure was threatened.

Within a few months, ITEL was on shaky ground. A short time later, it was history. ITEL’s stock was a true small cap-for some time it sold below $1, until Sam Zell bought it and changed both its capitalization structure and business. Today, ITEL is alive and flourishing, but the company is no longer in the computer finance business.            I

From an investor’s standpoint, small caps also lack liquidity. Small caps trade over the counter and are quoted on a bid (price to sell) and ask (price to buy) basis. Because fewer shares trade on a given day, there may be a wide spread between the two. For example, a stock that is quoted at “$10 bid and $11 ask” has a 10 percent spread. The stock has to move up 10 percent before you can break even.

It’s one thing to call your broker and ask him to sell 5000 shares of General Motors. Someone or some institution is always interested in G.M. (despite all the recent bad press). It’s far different to try to sell 5000 shares of American Small Cap.

PICKING THE WINNERS

Are small caps for you? It depends. Given the risk/reward ratio, a number of savvy chief executives will profit from the small cap run. Whether you are investing in small caps or large, always seek good value within a particular industry. Telecommunications is a growth sector, but that doesn’t mean all telecom stocks are winners. Sometimes a stock is cheap because it deserves to be. Better to find one that’s priced low in relation to earnings per share, cash flow per share, or hook value per share.

Keep in mind: A stock selling for $10 and earning $1 per share is no better bargain than the stock of a company selling for $50 and earning $5 per share. In fact, the risk of scooping up the $10 stock is far greater than that of the $50 stock.


CEO SELECTIONS:

Picks Of Your Peers

To buy or not to buy?

When it comes to small caps, the answer depends partly on whether the company you’re interested in buying a piece of offers a unique product or service. And if you do buy-particularly in light of the sector’s recent decline, as the experience of some CEOs shows-the question also may become when to sell or opt for a short play.

One executive bought into a company called Scoreboard-which specializes in baseball memorabilia-at $7 a share. Reasoning that the baseball card craze had plateaued, he contemplated shorting the stock when it reached $13. But every day that he planned to call his broker to execute the trade, the stock hit a new high. He watched it climb all the way to $40, then drop to $37. This time he acted. The jury is still out.

Another executive made the classic mistake of falling in love with a company. He invested in Interand, a telecommunications company with a technology that facilitated the transmission of images over telephone lines. The image system’s application was vast: Attorneys, for example, could modify contracts during negotiations and transmit them across the country within 30 seconds. Interand’s clients were major blue-chip companies, such as Texaco and EDS.

But one of the company’s fatal errors was to put all of its resources and energy into creating a specialized technology for Nippon Tel & Tel. The effort resulted in an order for 20 machines, but then follow-up sales from Nippon went dead. The company had neglected other key markets during the process, and the stock, which had risen to $17, began to erode. It’s now trading at less than a dollar.

Investors also can turn a handsome profit on negative news by shorting their investments. One took a short play on American Business Computer, an automated vending machine company. It was offered at $15 and fell to $2. The secret here involved shorting the stock, not buying it. 

-Merry Shells


Merry Sheils is president of First New York Equity, a registered investment advisory and financial services firm.