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Small May Be Attractive

It’s become an all-too-common refrain in the stock market: Small stocks are lagging bigger ones.

In the aftermath of Asia’s financial turmoil, investors once again are scampering toward the perceived safety of larger stocks. Since Gray Monday on Oct. 27, the Russell 2,000 small-cap index is virtually unchanged. By comparison, the Standard & Poor’s 500 has added 9.9%, even pushing to a new high before faltering again last week.

It’s anybody’s guess when small issues will run again. With so much economic and market uncertainty, big caps provide welcome cover to jittery investors. And since the ballyhooed January Effect--in which smaller stocks outperform at the beginning of the year--has been absent in recent years, buyers seem in no rush to scoop up smaller names.

Nevertheless, small-cap enthusiasts are optimistic, for a couple of reasons. First, analysts expect small-cap earnings to be strong next year. Second, small caps typically have little to no foreign operations, meaning they’re less vulnerable to the Asian debacle than multinationals.

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Small-cap experts are used to this drill. Like children at Christmas, they’re polishing wish lists of undervalued stocks--the ones they expect to move when the sector returns to favor.

The Times recently talked to a well-known newsletter writer and to several top fund managers to find out which stocks they like now. We focused on small-cap value managers who specialize in finding stocks that have been overlooked by the market.

Even in a market like this one, as some managers see it, there are still good bargains for investors willing to hunt for them.

“There are a number of areas that have been sort of unfairly ignored by the marketplace,” said Jim Haynie, co-manager of the Colonial Small Cap Value Fund, which is up 19% for the year to date. “There are a number of good opportunities out there, and they come from a variety of places.”

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But value is a lot like beauty: It’s in the eye of the beholder. At this stage of the bull market, it usually takes something serious for a company to come cheaply. That can mean it’s either grappling with its own financial problems or with industrywide ones such as pricing pressures.

The experts like oil drilling and service stocks, utilities and regional banks, and a smattering of high-tech and biotech names.

Among utilities, Bill Nasgovitz, who heads the Heartland funds in Milwaukee, likes El Paso Electric Co. and Tucson Electric Power Co. Both have been troubled and can be bought cheaply as they turn themselves around, he said. El Paso can be had for less than three times cash flow and Tucson for less than four. By comparison, the sector average is six times cash flow, and for the S&P; 500, it’s 12.

Income investors beware, however. Unlike with most other utilities, neither of these stocks pays a dividend, Nasgovitz said.

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“In a low-growth, low-inflation environment, these guys will do just fine,” Nasgovitz said.

Nasgovitz also likes biotechnology company Matrix Pharmaceutical Inc. Matrix would be a turnaround play, but this is a company with a solid financial foundation. It has little long-term debt, and its tangible book value is about $4 a share, including about $2.75 a share in cash, Nasgovitz said. The stock closed Monday at $3.56. Such a strong financial footing is rare in the biotech industry, which includes many companies that don’t even have earnings.

The company said two months ago that it would lay off one-third of its work force after its AccuSite genital-warts drug failed to win Food and Drug Administration approval because of doubts of its efficacy and side effects.

Despite that setback, Nasgovitz said, the company has approval for the drug in Ireland and the Netherlands and has promising cancer treatments in development in the U.S.

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For the truly courageous, there are closed-end mutual funds investing in Asia, some of which Nasgovitz has been buying. (Closed-ends operate like other mutual funds but trade on the New York Stock Exchange like equities. That means their prices are set by the market rather than by the value of their underlying holdings.) Here’s Nasgovitz’s reasoning: The Asian meltdown has chopped Asian stock prices 20% or more. Closed-end funds often trade at even greater discounts, so they could be cheap ways to play a rebound. Nasgovitz has bought Templeton Dragon, Morgan Stanley Asia Pacific Fund and the First Philippine Fund.

But the region’s problems are far from over, and Nasgovitz advises anyone buying those funds to hold them for two or three years.

Colonial’s Haynie likes oil driller Marine Drilling Co.

Oil stocks had a strong run this year, but many have been clipped lately on fears about increased Organization of Petroleum Exporting Countries quotas, the showdown with Iraq and the fact that the sector’s run has been so long already. Haynie, however, thinks the long-term picture is bright, with increased demand for oil worldwide.

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“All those [worries] have nothing to do with the fact that we’re going to need more oil,” he said.

The company trades for 11 times estimated 1998 earnings. Haynie also likes Pool Energy Services Co. and Veritas DGC Inc.

Nasgovitz is also a fan of oil, in particular some Canadian oil and gas producers, because, unlike U.S. companies, they have yet to be discovered by investors.

His favorite: Numac Energy Inc. Cash flow is $1 a share. And it can be picked up for less than four times cash flow, he said. He also suggests Buckeye Partners, Cavell Energy Corp., National Energy Group Inc., Petroglyph Energy Inc. and Petsec Energy Ltd.

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Furniture Brands International Inc. is another Haynie choice. The company makes furniture under the Broyhill, Thomasville and Lane brands.

Wall Street looks for the company to boost earnings 24% next year. And with Furniture Brands carrying out a cost-cutting strategy, the company can meet that profit goal without a commensurate boost in revenue, Haynie said. It’s priced at $20.88 now, and he looks for a price of $26 to $28 next year.

Haynie also suggests Innovex Inc., which makes components for disk drives. The stock has tumbled from a high of $40 in May to about $21. The problem is that disk-drive companies have been thrashed across the board lately. Several have issued so-called earnings pre-announcements because of falling prices throughout the industry.

Haynie, however, figures new personal computers will still need disk drives and older machines will need upgrades.

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“It’s a real good opportunity unless you see Armageddon in the disk-drive industry,” he said.

Andrew Addison, editor of the Addison Report in Franklin, Mass., likes bus company Greyhound Lines Inc.

Greyhound, also a turnaround play, has faltered for years with poor management, Addison said. But the company brought in a new chief executive almost three years ago and has been restructuring, he said. Insiders were heavy buyers in April and May, he said.

It’s gaining customers as railroad company Amtrak cuts back service. Greyhound also has the biggest market share among companies providing bus service between California and Mexico and Texas and Mexico, he said.

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“It had a terrible history,” Addison said. “There were a lot of people because of its checkered past who removed it from their radar screens and haven’t noticed it’s an entirely different company.”

Addison also recommends Downey Financial Corp., parent of Downey Savings & Loan. The stock trades around $27, but Addison sees it hitting the upper $30s next year.

The company, however, has seen its return on assets fall in each of the last five years. An ROA of 1 is considered a solid performance. Downey notched 0.42 last year. As with many other regional banks, its most attractive feature at the moment may be its allure as a takeover candidate.

Chris Bertelsen, manager of the Phoenix Small Cap Value Fund, also likes regional banks. His picks: Trustmark Corp., First Indiana Corp. and Whitney Holding Corp.

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But don’t invest solely on the hope of mergers.

“Takeovers are a lottery,” Bertelsen said. “You just don’t know when it’s going to happen.”

Not everyone likes banks. Naysayers believe the sector has gotten so much attention that it’s no longer a place for value players.

“Stay away from banks,” Nasgovitz warned. The group’s “pretty well been picked over.”

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Times staff writer Walter Hamilton can be reached at walter.hamilton@latimes.com

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Fishing for the Smaller Ones

When markets are uncertain, as they are now, promising smaller stocks often get overlooked. that can mean opportunities for investors. Here are issues that some small-stock enthusiasts are focusing on now:

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*--*

Ticker Mon. ’98 earnings ’98 est. YTD stock Company symbol close growth est. P/E price chng. Downey Financial DSL $27.63 23.6% 16 +47.8% El Paso Electric EE 7.06 12.7 11 +8.6 First Indiana FISB 30.13 9.2 17 +41.4 Furniture Brands FBN 20.88 23.9 15 +49.1 Greyhound BUS 3.75 650.0 13 -11.8 Innovex* INVX 21.44 18.2 8 -20.6 Marine Drilling MDCO 18.69 50.9 11 -5.0 Matrix Pharm. MATX 3.56 NA NA -41.9 Numac Energy NMC 3.75 -5.9 23 -6.3 Pool Energy PESC 22.63 53.4 12 +47.1 Trustmark TRMK 44.25 10.2 21 +73.5 Tucson Electric TEP 17.06 13.1 11 +3.4 Veritas DGC** VTS 39.63 66.2 18 +114.2 Whitney Holding WTNY 57.00 10.0 20 +61.1

*--*

* Fiscal year ends in September.

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** Fiscal year ends in July.

Note: P/E is current stock price divided by 1998 estimated earnings per share.

NA: not applicable

Sources: Bloomberg News, IBES

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