Small Cap Manager - August 2002

Issue #11, August 2002

By Richard Hefter, Editor, Small Cap Manager

Kent Williams has worked at some pioneering firms in his 33 years on Wall Street. He got his start at Weeden & Company in the late 1960s, which created Instinet and whose principal, Don Weeden, fought for negotiated commissions on the New York Stock Exchange. He was co-manager at Siebel Asset Management in the 1980s, working with Ken Siebel, one of the founders of Montgomery Securities.

Williams in his career has also provided strategic counsel and portfolio management for institutional clients at Merrill Lynch, Wood Island Associates, and U.S. Trust Company. He has lectured on behavioral finance at the Haas School of Business and taught portfolio management in Berkeley's Personal Financial Planning program. From 1985 to 1998, he served on the Trading Advisory Board to the American Stock Exchange, where he advocated for technology and transparency to the trading floor and for opening the specialist book to the public.

Selling Wood Island Associates to U.S. Trust at the end of 1998, Williams early this year formed Vista Asset Management, managing accounts for high-net-worth investors interested in small caps.

Why the focus on small caps?

We feel it's the area of greatest opportunity because of its very poor visibility relative to research coverage and liquidity issues. The lack of institutional research and sponsorship create market inattention and inefficient pricing into this area. We also feel right now that the macro trend factors are supportive of absolute and relative outperformance of the small-cap area.

How so?

The recession and the slowing recovery globally will continue to hurt large-cap growth. The strength of the dollar has hurt large caps by squeezing their margins and their ability to be cost-competitive in foreign markets. We've also seen the large-cap multiples compress and I think they will continue to be under compression. Under-funded pension liability, which is something very topical today, is another major issue that hits that group harder, as is expense treatment of stock option liabilities.

What are the current positives for small caps?

I think smaller companies in general have nimbler structures that allow them to create products and respond to market needs far more quickly. The big unspoken here is we're in a deflationary environment that is global in scope. That will allow for productivity gains to really drive earnings, and that's where small niche players and new products will be very important to provide earnings leverage. So this whole group will be fodder for acquisitions by larger companies seeking new products but that don't want to incur the risk of venturing out and creating new products unless they are tested in the market.

How do you select stocks?

We're looking for an 18-36 month horizon, looking for very positive returns over those periods. We spend a lot of time first looking at sectors we feel are poised to benefit from an emerging macro theme. Everything I look at is first done strategically top down and then bottom up. We're looking for evidence supporting what we think are more durable longer-term themes that don't evaporate. I also use some proprietary databases that can go back many years to assign a technical ranking in screening sectors, because I believe price is the greatest validator in the marketplace.

What sectors do you like?

As we look for pricing flexibility, two industries of interest right now are property/casualty and healthcare. Those are about the only two major industries right now that have any kind of pricing power that is, the ability to raise their prices.

Finance is another area I am looking at just because valuations are very attractive now. Regional banks are a big area I'm looking at. Because many of the small companies really don't have access to capital, a lot of times you'll find they have group relationships with their local regional banks, and I think regional banks also are going through some consolidation.

Can Research Bring Out Performance? The Evidence Suggests Yes!

By John Dutton, Director of Research, JM Dutton & Associates, LLC www.jmdutton.com

Small-cap stocks were particularly hard hit by the recent slide on Wall Street after having been significant outperformers over the last few years. Some technicians suggest this points to a bottoming process in the markets as investors throw out the proverbial baby with the bathwater, selling off even defensive and value holdings.

Whatever the market implications, from April 16 to July 19, the Russell 2000 fell 26.1%. Interestingly, stocks followed by our independent research firm, JM Dutton & Associates, gave back just 11.1% during the same period.

As of April 16, we had reports out on 12 small-cap companies. These are companies that prior to coverage by Dutton & Associates had little or no Wall Street coverage. Our hypothesis has always been that good research coverage, widely distributed as ours is, can have a positive impact on the stock price and trading volume of good companies.

That hypothesis not only proves correct when measuring performance during these tumultuous past three months. In another test, we measured the change in stock price of our covered companies 90 days after release of their initial report. We have found that on average these companies have gained 18.83% after 90 days since we released our first company report last October. By contrast, the Russell 2000 returned, on average, just 2.94% during those comparable 90-day periods.

That's more than 6 times the return of the small-cap benchmark index - strong evidence indeed that research coverage has an impact. Volume, too, picked up in those 90 days ... by 125%!

Again, our formula is: Credible Research +Good Companies +Wide Distribution = Enhanced Shareholder Value. Our 18 analysts, many of them CFAs from well-known Wall Street firms, have on average more than 20 years of Wall Street experience each. The companies we cover are often ones where, to use the terminology of the fund manager featured in this month's Small Cap Manager, there is a significant gap between the value of the business and the market price.

Adding to that, our distribution is second to none, as we are not only featured in all the traditional Wall Street databases and consensus estimates (Zacks, Multex, First Call), but our independent model allows us to be picked up by investment banks, numerous financial Web sites, email publications like this one to more than a million recipients, and much more.

Thanks for taking the time to get to know us and our covered companies better. Please visit our Web site to view all our reports at www.jmdutton.com.

What do you look for in your bottom-up analysis?

We're looking for companies well positioned in an open-ended market, companies with a dominant share of a niche market representing barriers to competitors. We're looking for significant operating leverage and cost-structure advantages. We're always looking for significant free-cash flow and low leverage. We also look for accelerated earnings from operations and attractive valuations.

More important than the quantitative measures are the qualitative issues. We're looking for management considered above average in the industry, with ownership in the company that might in some cases be three to four times their base salary, that has an alignment with shareholder interest. We're also looking for a focus on quality of earnings; obviously, transparency is a big thing. On the accounting side, we look at expense return on pension assets, and the aggressiveness: Are they expensing returns on pension assets at a particular rate? Is there a pension surplus? What is the ownership relative to float?

You're obviously both growth and value oriented, correct?

That's right. We're looking for earnings per share growth of greater than 15%, and a P/E ratio that's in some cases substantially less than the growth rate. We're looking for companies at the historically low end of their price range, or the low end of their price-to-book or price-to-earnings range. In addition, we want cash flow growth that is well over 20%, sales growth over 10%, margin growth over 10% of prior year's comps. ROE of 15%. Financially, we're looking for low interest expense, long-term debt relative to EBITDA less than a very small number. I'd prefer not to be specific in terms of my ratios. We want net working capital that could be 35-50% of the stock price. We're also very opportunistic.

How so?

We're looking for companies in which there may be large financial players taking a stake. We're looking always for a catalyst such as: Might there be some kind of Street coverage? Are there share buybacks or restructuring likely? Any evidence of insider buying?

Any examples?

I don't want to talk about specific names, but one company I'm looking at right now in is the dental area. I just met with the CEO. They dominate their market, they've got new technology, a huge patent position, barriers to entries, all the right filter points, and it's an orphan, no one cares about it. Of their nearest competitors, there's a couple that do well at marketing, but as you talk to the dentists and other users in the marketplace you find they are huge proponents of this company because its technology really improves their returns. There are only so many patients you can see, only so many hours in the day, but you can do different treatments, you can provide different specialists. They provide a way to leverage the end user.

What lessons can we learn about small caps from your years of experience in the field?

People like to think in a linear fashion and they do this when looking at valuations. That's why people pay higher multiples for consistent visibility and predictability of earnings. You don't get that in small caps. If anything, you get probably a lot of volatility, and you have to stay the course and have a sense of longer time horizons, higher risk profile and obviously higher reward, as small caps tend to outperform in the long run.

How has research coverage of small caps changed over time?

I think research coverage has always been few and far between, although it has become even more so tied to banking and other types of ancillary services. Also, we lack forums like the Montgomery conferences. I've been on the American Stock Exchange board since 1985, and the American, which has this proprietary hold on small caps, has never been able to appropriately address how to market companies in this area. There is definitely a need for these companies. They need a forum to talk and to have their stories appropriately researched.