Bit of Pro Advice on Small Stocks

By RUSS WILES

Oct. 27, 1998 12 AM PT

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Small-company stocks are at a crossroads. After plummeting from late April through early October, many smaller issues have rebounded in recent weeks.

The Russell 2,000 index, a benchmark for the small-cap sector, plunged 37% between April 21 and Oct. 8. But the index has rebounded 20% since and has gained for nine straight sessions.

Have we seen the worst of the sell-off? Or is this a false start?

Besides the overall economic backdrop--specifically, concerns about a slowing economy in 1999--always-volatile smaller stocks face special issues at this time of year.

For example, many analysts warn that portfolio managers may still be unloading some of their biggest stock losers over the next couple of weeks to generate losses that can be used to offset capital gains for tax purposes. That could put new downward pressure on beaten-up smaller issues.

Still, many small-stock mutual fund managers say the carnage in these issues, which was far worse than the declines in most blue-chip stocks, has left some spectacular bargains for the picking.

Here, managers of three small-stock funds explain their strategies amid the market rebound. Although their investment styles differ, all three funds generally target stocks with market capitalizations (stock price times number of shares outstanding) under $1 billion, and all have performed better than the average small-stock fund over the last five years.

Berger Small Cap Value

A value investor, Berger Small Cap Value fund manager Robert Perkins scans the daily list of stocks hitting new 52-week lows to spot potential investments. “We like to buy stocks that already are down 60% to 70% from their highs,” he said.

Perkins concedes that many of these laggards are depressed for a reason, so he must identify the problems and determine if they can be corrected within the next couple of quarters.

That’s why he gravitates to companies that, although troubled, sport strong balance sheets. “The ideal is to find companies with a lot of cash but little debt,” he said.

Perkins says he has no trouble finding purchase candidates these days. “The small-stock universe is cheaper than it has been at least since 1990,” he said.

But he doesn’t think small-cap investors are out of the woods yet, because he believes that blue-chip stocks remain overpriced and will need to retreat more before a sustained rally can advance. A big-cap decline could drag smaller stocks lower again as well.

“But once this washes out, there’ll be a lot more money to be made in the small-cap arena,” he said. “Small stocks offer much better values than any other area of the market.”

Berger Small Cap Value normally maintains a cash position between 2% and 20% of assets. The position recently was at 8%, as Perkins has been adding stocks in several areas, including banks and thrifts such as Webster Financial (ticker symbol: WBST), a small Connecticut bank.

He also has been picking up “fallen growth” companies such as semiconductor equipment makers SpeedFam International (SFAM) and Brooks Automation (BRKS), which trades at less than two times cash flow. Another favorite is Cognex (CGNX), a robotics firm.

The fund also has a considerable weighting in telecommunications, energy and real estate stocks.

Its biggest holdings: CCB Financial (CCB), Knightsbridge Tankers (VLCCF), Jones Intercable (JOIN), Jostens (JOS) and Federal Signal (FSS).

Berger Small Cap Value has already paid a capital gains distribution of about $1 a share this year, so taxes don’t pose much of a short-term consideration for investors mulling a purchase.

Eclipse Equity

This fund’s co-managers, Kathy O’Connor and Wesley McCain, play it strictly by the numbers. They combine a value approach with “quantitative” analysis to identify stocks that are both “good and cheap.”

For example, Eclipse Equity’s holdings as of Sept. 30 featured stocks selling at an average price-to-book-value ratio of 1.9, a price-to-earnings ratio of 15.4 and a price-to-cash-flow figure of 8.8--all well below comparable readings for the small-company Russell 2,000 index.

“Our portfolio is designed always to be cheap to our universe of 4,400 small companies,” McCain said.

That has helped power the fund to an 87% gain over the last five years, versus 59% for the average small-cap stock fund, according to Lipper Analytical Services.

McCain and O’Connor, unlike many small-stock managers, don’t visit companies, nor do they consider profit and sales forecasts, because such estimates aren’t entirely reliable. “We look only at past data,” McCain said.

In addition, they steer clear of initial public offerings, partly because they prefer seasoned companies and partly because many firms time their initial stock sales to when their business prospects are near a cyclical peak.

Eclipse Equity’s managers haven’t changed their focus amid the drubbings sustained by small stocks in recent months, as the fund stays fully invested at all times, spreading its assets among more than 300 stocks. Still, “the market turmoil has created some interesting new opportunities for us,” O’Connor said.

“We sell to replace stocks with better opportunities,” McCain said.

One recent addition: steelmaker LTV Corp. (LTV), which at $6.13 today is down from a 52-week high of $14.56. “The steel industry is feeling the onslaught of international dumping,” O’Connor said. “Even though the company is very depressed, all you need is a little improvement in its pricing power to see a noticeable improvement on the bottom line.”

McCain and O’Connor, like other value managers, look for some type of catalyst that will enhance their companies’ prospects while causing other investors to take notice.

The fund’s five biggest holdings: Ryan’s Family Steak Houses (RYAN), Astec Industries (ASTE), Tech Data (TECD), Giant Cement Holdings (GCHI) and Syncor International (SCOR).

John Hancock Emerging Growth

Unlike the Berger and Eclipse funds, which are more value-oriented, John Hancock Emerging Growth looks for smaller companies that are expanding sales and earnings by at least a 20% annual clip.

Lead manager Bernice Behar also favors firms with dominant market positions and visionary, shareholder-focused managements.

The fund maintains a fully invested posture through thick and thin. Behar concedes that for much of the summer decline in smaller stocks, she had trouble identifying a “catalyst” that might reverse the sector’s sinking prospects, as investors fled all sorts of higher-risk securities.

But she now feels that investors have finally come to terms with the reality of a global economic slowdown, while the Federal Reserve Board also recognizes that the economy needs help to stay out of recession in 1999. “The last business cycle appears to be at an end, and the Fed is now applying the medicine,” she said of the central bank’s two recent interest rate cuts.

Behar cautions investors to expect more volatility, but she also thinks small stocks are poised for a sustained period of outperformance compared with large blue chips that haven’t suffered the same magnitude of declines.

Simply put, she believes that prices of many smaller stocks fully reflect the risks in the economy.

Her current stock favorites include hard-hit semiconductor-related companies such as Novellus Systems (NVLS) and selected consumer issues like retailer Abercrombie & Fitch (ANF).

The fund’s five biggest holdings: META Group (METG), Metromedia Fiber Network (MFNX), Adelphia Communications (ADLAC), Network Appliance (NTAP) and On Assignment (ASGN).

Russ Wiles is a mutual fund columnist for The Times. He was recently awarded the 1998 Excellence in Investor Education Award from the Mutual Fund Education Alliance.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

How the Funds Have Fared

Berger Small Cap Value

Assets: $200 million

Maximum sales charge: None

Minimum investment: $2,000

Phone:(800) 333-1001

Total returns

Year-to-date: -6.3%

12 months: -5.7%

5 years: +115.2%*

Eclipse Equity