Small-Cap Tsunamis: How Scott Sterling Johnston Gets in Front of the Wave

By Richard Hefter, Editor, Small Cap Manager

Scott Sterling Johnston’s Micro Cap Aggressive Growth portfolio was ranked #1 for the last year, three years and five years through June 30, 2002 by Pensions & Investments. It’s a fact that Johnston, a 30-year industry veteran, mentions to us late in our interview, an afterthought among numerous industry accolades.

Johnston is the principal of San Francisco-based Sterling Johnston Capital Management, which runs small-cap and micro-cap managed accounts and two hedge funds, and has grown its managed assets from $50 million in 1996 to $600 million today.

Johnston began his career an auditor with Andersen Consulting and later joined Smith Barney & Co. as an institutional salesman. He was chief executive of Security Pacific Bank's investment advisory subsidiary from 1981 to 1985, where he started the Pacific Horizon family of mutual funds and was responsible for over $5 billion in managed assets. Prior to founding Sterling Johnston in 1996, he built Apodaca-Johnston Capital Management from $10 million in assets in 1994 to over $500 million in 1996, with one of the top performance records in the country.

What professional experience has most influenced you as a small-cap manager today?

I believe my sell-side experience as an institutional salesman for Smith Barney in New York was an important formative experience. It helped me understand the way Wall Street develops an idea, packages an idea, and sells an idea. I learned that stocks are really sold, not bought. If you’re a money manager and can understand the way catalysts and stories develop, and how a stock’s story can create imagination and the fire that will drive that stock much higher, you can use that to often get in front of the story and in front of that big marketing effort on the Street.

Another thing I learned is that when an institution wakes up and decides they really have to own a stock or a theme or industry, it creates this giant tidal wave, this giant tsunami that can push that stock to the moon because you’ve got this huge amount of money flowing into a name. So I’ve discovered a long time ago that if there’s some way I can get in front of that big wave of institutional buying power when these folks just have to be there, or conversely sell or short stocks in front of that big move, you can really use that tsunami to your advantage.

How do you get ahead of that wave?

The way we know it’s going to hit is is we get an early call from the regional brokerage firms we do business with. We do business with over 120 regional firms, resulting in a massive amount of information. We want that information. We call it the information advantage. We feel that the regionals likely have a closer pipeline to what the company is really doing than your big huge investment banks because the companies are in their own back yard. So you’ve got a higher quality line of information, but also I’ve got relationships now that go back with these regional firms 20-25 years. So I’ve got that human element, and while we have a healthy skepticism of the conflicts that exist between research and investment banking, we have a network of firms that I’ve been doing business with, and now my staff has, for years and years where you’re getting a high-quality call. And it’s an early call. I’m not saying we get a call before Fidelity, but quite frankly we get it very often before the big boys.

Also, there are 15 of us at our firm, seven investment professionals plus trading, and we all sit in one big room where we sift through information and make decisions quickly. The larger firms, which are big, bureaucratic, and ponderous, take a long time to process that information, while we’re a boutique and can focus quickly. So we’re getting an early call and can start our research process before others and come to a decision much sooner than these bigger shops, and then get our position established before that big wave hits.

It must help, obviously, that you focus on small caps.

Yes. We’re obviously in the micro- and small-cap area, which I’ve been in for 25 years. There are about 5,000 names under $1.5 billion market cap, so the playing field is large and analyst coverage is slim. Whereas there are between 15 and 17 firms covering mid-cap and large-cap stocks on average, there are only three or four firms in our area of the market. So it’s an inefficient area of the marketplace. If you’re willing to dig in, roll up your sleeves and work hard, you can find out information about these small companies that others don’t know and use it to your advantage. A small-cap stock can really move when others discover this information that hopefully we’ve already found out.

How big do you let your stocks grow to before selling?

We sell our stocks when they get to a $2 billion market cap. That’s critical and it really gives us an edge. When a company gets to about $2 billion, they run into the law of large numbers, which is a disadvantage because they’re getting up there bigger and bigger and it’s tougher to keep generating those big growth numbers. But more importantly now you’ve got 10-12 firms covering the stock, not the two or three that were in there. Information is now widely disseminated, people know the story, so we’d much rather sell that one and go back and find a smaller name. This is contrary to most managers that let the winners run or expand the definition of what small cap is, stretching the upper boundary. We have always been purely small cap.

What are your buy criteria?

We have six buy criteria, and they haven’t changed in 25 years when I started managing money in 1976. Firstly, the stock’s got to have dramatically accelerated earnings. As a manager we have no interest whatsoever in a company that’s growing trend line is as high as 30%.

That would be considered a growth stock. Why wouldn’t you own it?

The reason is that 30% growth generally is reflected in the price of the stock. We want something going from 30% to 60% or from 10% to 50% because you have this giant change. We have about 80 names in our portfolio, and our typical company if you look at our forward earnings for next year has earnings projected at 40% year over year. That’s a huge change. If everything remains constant, meaning that the multiples remains the same, then that stock ought to be up 40% because the earnings are up 40% and it’ll go up in line with those earnings. But, more importantly, because we’ve discovered the changed nature before others, and realized it’s now on a higher growth plane, that company is going to get a multiple expansion, and that multiple expansion will drive the stock higher, so we get a double whammy. We’re not interested in singles and doubles, we want triples and home runs.

What are your other criteria?

The second one is a strong balance sheet, strong and improving financials, and no debt or little debt.

Third, we want to have strong company relative price strength, meaning that the stock is acting better than the market. If there’s a number attached to it, generally ours is 70 or better, but the point is if a stock is acting well, hitting new highs, and under accumulation, that’s a good sign as most of the time the market is smarter than we are.

The fourth one is we want the industry the company is in price-wise to be acting well, reflecting good things are happening to the companies in it. Often, you might have a great company with great earning but it’s in an industry that’s under a big cloud. If an industry is under a cloud, maybe it’s a government regulation or something like that, that can absolutely kill the group, so we’ll generally avoid it until that cloud has moved on.

Fifth, we want low institutional ownership.

Why low ownership? That sounds counterintuitive.

Often there are $350 million market cap companies that by definition are micro cap, yet are already over-owned institutionally. If you’ve got Morgan Stanley, Goldman Sachs, and Smith Barney that took them public six months ago, by and large the story is already well known. It might be a good stock, but the difference between a good stock and a great stock is one that really moves and goes up, and that generally has to do with discovery. We want to find something is less well known but is undergoing a change.

That change is the sixth thing we look for: the catalyst. We usually want our catalyst to happen within two to three months.

What is your view of the market going forward and small caps’ place in it?

I think we’re in a secular bear market, where we go sideways for at least a decade. When I got into the securities and investing business in 1972, the Dow first hit 1000. It went until 1982 until it effectively broke through 1000 again, a decade of 10 years when stocks went sideways. I think we’ve got a decade going forward that’s going to be similar to that period where the stock market is going to have a very difficult time. The technology blow off and bear market for tech stocks that we’ve experienced now for two-and-a-half years will continue. That sector should have at least two bear markets, similar to what happened when the Nifty 50 peaked in 1972 right before the 1973-74 bear market and had such high valuations they basically never really recovered in the 1975-76 bull market and suffered again.

What does this mean for small caps?

In terms of small cap versus large cap, you’ve got to remember that for 18 years from August of 1982 through March of 2000 the annualized return for the S&P 500 was about 18%. That was off the charts. The Russell 2000 for that period did about 13%. The Ibbotson studies out of Chicago have shown that the annualized return for stocks this century has been about 9-10%. So to get us back to central tendency we’re going to have a long drawn-out bear market and sideways market and we’ll probably be fortunate to see like 6-7 % returns on the overall markets over the next 10 years.

I also think that where the action is going to be will be in small caps. From 1976 through 1982, after that first awful bear market of 73-74, you went through a period of six to seven years when small caps stocks way outperformed large-cap stocks. The annualized return for the Russell 2000 was roughly 16% for that period of time. The S&P 500 only did 9%, completely the opposite of what happened in that secular bull market from 1982 to 2000. I think you’ll see that again.

Looking forward you still have got so much money that went into index funds where they had to own these large capitalization names. Those sell programs will probably still continue, and they’ll have to find a home, and that home is going to be small- and mid-cap stocks. The reason is they’re still way undervalued relative to large-cap stocks on an earnings to growth rate. Secondly, you’ve got simpler stories you can understand. You don’t have this complicated financial structure where it’s difficult tot figure out what’s off the balance sheets and what’s on them. You’ve got simple, clean stories where maybe at least as far as small-cap growth stocks are concerned they’ve got a neat product or service or something that will be able to grow revenues and earnings almost regardless of the direction of the economy by and large, and the market and investors are going to want to own those names.

What are your thoughts on the immediate months ahead?

I feel we’ve probably bottomed this year and are going to have a pretty good 2003. This issue of confidence for the market is going away now with CEOs and CFOs having to sign off on financial statements. We haven’t seen all of that behind us, but as an issue, management is going to think long and hard before they start playing a lot of games. Also, the market has exerted a lot of discipline on the companies that have had screwy financial statements, and so as an issue I think investor confidence is going to begin to increase. By 2003, with all this behind them, companies may well be saying, “You know, we’ve got some pretty decent numbers.” You’ve also got this mid-election year cycle phenomena, which is pretty regular going all the way back to1934. Mid-election year fall seasons are generally are about the low, so folks will begin to look on the following year with more optimism. We’ve gone through 11 discount rate cuts in the last two-and-a-half years, so you’re beginning to see signs of life.

© 2002, The SmallCap Manager, An AdviceTrade Publication, Sponsored by JM Dutton & Associates www.jmdutton.com