Small-Stock Pros Hunt for Fundamental Appeal

“Cheap” is a relative term. In the battered small-stock arena, veteran investors care far less about how much the dollar value of a stock has fallen. Instead, they measure “cheap” by some proven yardsticks of value. The idea is to avoid getting trapped in bad stocks that will only get worse and, instead, pick those that have fundamental appeal--and hope others eventually notice.

James B. Cloonan, chairman of the American Assn. of Individual Investors in Chicago, has for the last four years maintained a 25-stock portfolio of what he calls “shadow stocks”: little-known, under-followed small-company shares that trade in the shadow of their larger brethren.

Cloonan applies some tough screens in choosing shadow stocks. For example, a stock’s price-to-book-value ratio--the share price divided by the company’s per-share net worth--must be 0.7 or less, so that an investor is buying $1 worth of assets for 70 cents or less. Cloonan also wants to see a low price-to-sales ratio, to guarantee that significant revenue backs up each share.

Also, each company’s market capitalization (share price times number of shares outstanding) must be between $13 million and $100 million. A company must have earned a profit over the previous year, and the stock must trade for at least $4 a share.

It’s a simple approach, Cloonan says, but at the very least it’s a way to arrive at a list of small companies that are real businesses. Judging the rest--how good management might be, for example--takes a lot more work, he concedes.

The portfolio now contains such nonhousehold-names as Tranzonic ($16 on Friday, American Stock Exchange) and Federal Screw Works ($37.75, Nasdaq). Stocks are sold if they reach certain limits of price-to-book or market capitalization, or if a company begins to lose money, Cloonan says.

He says the shadow portfolio’s value has doubled in four years, a performance that he admits lags the blue-chip Standard & Poor’s 500 index’s gain. Adjusted for risk, however, the portfolio has done better than the S&P;, he says.

The Babson Shadow Stock portfolio in Boston (phone: [800] 422-2766) is a mutual fund that picks stocks along similar lines and was set up with Cloonan’s guidance. But in practice, the fund’s returns have lagged the average small-cap value stock fund’s return over the last three years, according to fund-rating service Morningstar Inc. Still, for investors who believe there is gold in small-stock rubble, the mutual fund concept at least offers the protection of a well-diversified, screened portfolio--something that’s tough for small investors to build with these stocks.