Small Stocks: Ease In Over Time, Diversify

Small stocks are hip again. But that return to hipness has happened so fast, some investors worry that it must be over already.

Since mid-January, the NASDAQ index of 3,918 mostly small stocks has soared 34%. That’s twice the gain that the index saw overall between year-end 1985 and year-end 1990.

Many investors who don’t own small stocks know that they should. But buy now? After this run-up?

Take a tip from veteran small-stock investors: If you try to time this market, you’ll probably never get in. And you’ll probably regret that sin of omission as the 1990s wear on and the economy grows.

Small stocks were red-hot in the early 1980s, cold in the late 1980s and now are in vogue again. They have returned to favor largely because they were ignored for so long--the stocks became ridiculously cheap relative to the companies’ earnings power. That’s the way it is in small stocks: long periods of famine followed by long periods of feast.

If you believe that small stocks are once again beginning an extended run on Wall Street, you face the question of how, and what, to buy. The best advice, say the experts: Commit yourself to a portfolio of at least 10 small stocks or stick with small-stock mutual funds. Either way, lower your risk by easing in; plan to buy once a month during the next six months rather than all at once now.

Here, three veteran money managers who specialize in small stocks share their strategies and some of their favorite stocks:

* Stuart Roberts, manager of the $25-million Montgomery Securities Small-Cap stock mutual fund in Denver. “I am not a market timer,” says Roberts, who joined Montgomery last year after a stellar career with the Founders mutual fund firm in Denver. “I’m a long-term investor. I pick good companies and plan to own them for three to five years.”

His fund holds 74 small stocks. Roberts expects the overall earnings growth rate of his companies to be 24% a year over the next three years. The average stock in the portfolio sells for 16 times estimated 1991 earnings, he says. And because that price-to-earnings figure is well below the 24% growth rate expectation, Roberts figures that he’s still got some bargains, even though his fund is up 35% so far this year.

The Montgomery fund is an eclectic mix of stocks. For example, Roberts owns Leslie Fay ($19.625 Friday, NYSE), a high-quality women’s apparel firm that he says still is cheap because Wall Street remains fearful of a sustained decline in consumer spending. Fay sells for 13 times its most recent four-quarters earnings per share.

Roberts also likes Harley-Davidson ($29, NYSE), the king of U.S. motorcycle companies. Don’t think of Harley as a smaller version of a car company, Roberts says. “This is a leisure-time growth company,” he argues, and yet the stock sells for just 11 times expected 1991 earnings per share. Annual earnings have grown consistently since 1987.

Overall, Roberts says, Wall Street is still suspicious of small stocks, and for that reason “earnings expectations are low.” The surprise of the next few years will be how well these companies perform, he contends.

* David Evans, research chief for the $38-million Robertson Stephens Emerging Growth stock mutual fund in Avon, Conn. The Robertson fund’s share price has jumped 31% this year. Evans admits that, given small stocks’ healthy rise, “you have to cast your net a little more broadly now” to find screaming bargains. “If a small company’s record is spotless, it’s probably selling at 30 times earnings already,” he says.

So he’s looking for companies that have been deserted by Wall Street just because they’ve had minor problems over the past six months.

One such company is Irvine-based retailer Wet Seal ($15.75, OTC), Evans says. The company, like many retailers, had a lousy Christmas because of the economy.

But Evans remains impressed with Wet Seal’s merchandising concept of “packaging” casual wear for teens--that is, a teen shopper in a Wet Seal store is more likely to buy an outfit of several pieces of clothing than just one piece. Evans believes that the company can earn $1 a share this year.

Another Evans favorite is Failure Group ($24.50, OTC), expected to earn about $1.20 a share in the year ending May, 1992. The Menlo Park, Calif.-based engineering company serves a somewhat strange market: It investigates disasters, such as product failures and accidents, and thus helps companies avoid recurrences by spelling out prevention techniques.

The only problem Failure Group has is that it isn’t widely followed by Wall Street, partly because brokerages have slashed their analyst staffs so drastically in recent years, Evans says. “This is in essence a unique company,” he says, and its growth rate should easily continue at 20% a year. “This business doesn’t go away.”

* Jack Granahan, co-manager of the $325-million Vanguard Explorer stock mutual fund in Waltham, Mass. The Explorer fund, up 26% this year, is heavily invested in technology companies. Granahan has some advice for investors who were smart enough to buy tech stocks last year and now are sitting on huge profits: Don’t be afraid to sell some.

He has recently been trimming holdings in such stocks as semiconductor-equipment maker Novellus Systems ($19.125, OTC) and computer networking firm SynOptics Communications ($49.25, OTC). These are still excellent companies for the long haul, Granahan says--but the stocks have gotten a little ahead of themselves in the short term. Still, he says, “in none of these cases are we eliminating the stocks” altogether.

The technology story remains a potent stock play for the early 1990s, Granahan says, because what the nation and world are witnessing now is a “harvesting” of tech seeds planted in the 1980s.

Computer networking technology--the electronic marriage of different types of computers and other equipment--is creating a much more efficient workplace and is opening new vistas for home-computer users, Granahan says.

So if you don’t own emerging tech stocks, he warns, you’re ignoring one of the driving forces in the world economy today.

Readers who want more information on either the Montgomery Securities or Robertson Stephens funds should contact the companies’ main offices in San Francisco. Information on the Explorer Fund is available from Vanguard Group in Valley Forge, Pa.

* STOCK, FUND CHARTS: D2