Still Like Small and Mid-Cap? Maybe He Can Help

Few investors are embracing small and mid-size stocks today. But for contrarians who want to shop in this beaten-up sector, Jim Collins may be able to offer some guidance.

The veteran Orinda, Calif., advisor’s stock-picking methodology has led his OTC Insight newsletter to annualized returns of 27.3% over the 10 years through June 30, according to the watchdog Hulbert Financial Digest in Alexandria, Va., which evaluates newsletters.

That compares with a 17.6% annualized gain for the Wilshire 5,000 stock index. But with its focus on small and mid-size stocks, OTC Insight’s picks naturally are volatile, with a risk factor 2.7 times that of the Wilshire, Hulbert says.

Collins, 64, began investing for his own account in 1956, but began his career as an engineer, working at such companies as General Electric Co., Raychem Corp. and Teledyne Inc. He received an MBA from Harvard, and in 1967 he entered money management, joining a San Francisco mutual fund group called ISI. Next he worked in venture capital and at an investment counseling firm before joining Wells Fargo Investment Advisors in 1973 as a senior portfolio manager.

A decade later he founded Insight Capital Management Inc., the publishing arm for OTC Insight. His money management firm, Insight Capital Research & Management, oversees nearly $1 billion in institutional and private accounts. The firm serves clients with at least $100,000 to invest, charging up to 1.5% in yearly fees.

Collins also manages the $23-million Dominion Insight Growth mutual fund, but its performance has been less impressive. Fund tracker Morningstar Inc. penalizes the fund for its volatility, giving it only one star out of a possible five. But Dominion has performed fairly well against similar competition, beating 52% of its mid-cap rivals over the five years through June.

Collins explained his strategy in an interview with Russ Wiles, a Times mutual fund columnist and financial writer based in Phoenix.

Times: Take us through your three-step process for picking stocks.

Collins: We start by screening about 6,700 companies--virtually everything that trades on the New York Stock Exchange, the American Stock Exchange and the Nasdaq National Market--by computer. Then we take the top 500 companies from the computer screen and look at the fundamentals for each one. That reduces the number of candidates to about 120. Then we do a performance check on those 120, which reduces it to 50 to 60 companies, from which we develop portfolios of perhaps 28 to 36 stocks.

Times: What are you screening for?

Collins: We rank stocks according to which ones have delivered the most reward [highest performance] per unit of risk. Technically, we measure a stock’s “alpha” and divide by its “standard deviation,” a volatility measure. We’re looking for stocks that have a long-term track record of beating the market--that is, companies with high alphas. But we include standard deviation because we want to know just how volatile each stock has been. When you get into growth stocks, you’ll find that they’re quite volatile. We don’t invest in really small companies. We ignore stocks trading for less than $6 a share.

Times: Why?

Collins: Generally, we’ve found that they are very volatile, and it’s hard to find quality companies trading below $6 a share.

Times: What sort of fundamentals are you looking for?

Collins: We’re looking for high growth rates of both sales and earnings, along with a high return on equity. We’re also looking for firms with very strong management teams and strong products. And we prefer little or no debt--certainly no higher than the industry averages. Fundamental analysis is the key part of the process.

Times: How do you assess good management?

Collins: We used to visit companies, but it seemed like we were living on airplanes every third week. Now we attend Wall Street conferences geared to small and mid-size companies, where up to 120 companies or so make presentations. Another way we assess management is by giving very careful consideration to the management discussions in annual reports and other documents. We’re checking, generally over a three-year period, what they said about the business--what their goals were and what they accomplished. Also, we look at returns on equity. If a company can generate a high return on equity, that says a lot about management. Finally, we check for managements that can manage their earnings. . . . What you like to see with growth companies is a steady increase in earnings per share, not erratic behavior, except for cyclical or seasonal factors.

Times: What’s involved in the performance check?

Collins: We go back over three or four quarters and analyze how much a stock went up. Then we’ll evaluate that performance against all stocks. If the company shows up among the top 15% of performers, then we’re interested. The reason we favor these high-alpha stocks is that they do turn in pretty good returns. There’s a saying that “the trend is your friend,” and there’s some truth to that.

Times: Your newsletter’s performance has been quite impressive, but the mutual fund you manage has been mediocre at best. What gives?

Collins: Usually the fund’s performance runs in the top half of its group. What really took it down was a drop of 23% in the fourth quarter of 1997. We also lagged the market during the fourth quarter of 1996. But in 1995, this fund was up 66% versus 26% for the Russell 2,000, so it has a lot of upside potential. We’re expecting good things, since we think earnings for the stocks we hold in the fund will be up over 32% this year and 29% next year.

Times: Can you name a few holdings that illustrate what you’re looking for?

Collins: One of the better candidates is HealthCare Financial, a company that offers asset-backed financing to health-care service providers. It’s a conservatively run firm with a good growth rate. We’re looking for earnings to be up 52% for all of 1998 and 31% for 1999. A lot of our favorite stocks in the high-tech area are health-care firms. We also like a company called Engineering Animation, which develops three-dimensional visualization technologies. They have two basic product lines. One is used in manufacturing to create digital prototypes. The other involves multimedia products for use in education and entertainment.

Other technology holdings include Dell Computer and two software companies, Compuware and Legato Systems.

Compuware’s software products help programmers improve the efficiency of their existing mainframe operations. We think earnings for the year ending next March will be up 40%, followed by a gain of 33% in March 2000. . . . Legato provides software that, among other things, generates backup data. . . . We expect earnings to be up 54% for the year ending in December and 47% for the year ending in December 1999.

Times: Any non-tech favorites?

Collins: Retail stocks also are doing very well at the moment, reflecting high consumer confidence. We like a company called Pacific Sunwear of California, a retailer of teen casual apparel, footwear and related items. We’re looking for earnings in January 1999 to be up 40% for the year, followed by a 26% gain for the year ending January 2000. Another favorite is Paychex, the second-largest payroll accounting firm in the U.S., with 270,000 clients. We’re anticipating a 33% gain in earnings for the year ending May 1999. . . . We also like Safeskin, a rapidly growing company that makes disposable latex gloves. This is a commodity business, for which you need automated, low manufacturing costs, which Safeskin has. We’re expecting 35% growth in earnings this year and 26% next year.

Times: How long do you tend to hold stocks, on average?

Collins: About nine months. Relatively high turnover is one of the prices you have to pay when investing in growth stocks.

Times: How do you determine when to sell?

Collins: The No. 1 reason we sell relates to a breakdown of a company’s performance relative to market benchmarks. Probably 80% of the selling that we do is for this reason.

We buy stocks when they rank among the top 15% of all stocks in terms of performance. But there comes a day--maybe a month later or three years later--when it starts to under-perform its benchmark. We’re not technical analysts, but we check to see if the stock is helping us do the job we’re hired to do, which is beat the market. When we see a stock’s price performance break down, we sell. Perceptions today drive stock prices more so than the real fundamentals of a company. Perhaps only 20% of the time do we sell because of changing fundamentals or because a stock’s riskiness has changed.

Times: You have 18 model portfolios in the newsletter, but they all own more or less the same stocks, albeit in different proportions.

Collins: We do vary weightings depending on the amount of risk. But all of these portfolios are fairly aggressive, even the “conservative” models. We’re not talking about something that’s designed for widows and orphans.

Times: Do you tend to stay fully invested?

Collins: Yes. Trying to time the market doesn’t work. If we suspect that we’re heading into, say, a period of higher interest rates, we’ll pay a lot more attention to the standard deviations of the stocks we own. We’ll favor the more conservative holdings to reduce the volatility of the portfolio.

Times: What’s your broad view for the economy and stock market?

Collins: We think we’re in a very good investment environment. Looking forward, interest rates are likely to stay low, with inflation likely to come in below 2% this year--and that’s with a consumer price index that probably overstates the true rate of inflation. Also, corporate earnings aren’t going to crash. If you exclude a couple of weak sectors such as oil and semiconductor companies, you’ll find that earnings for the first quarter were up about 8.6%. We think earnings for most companies will finish the year up at least 6%, and maybe 6% to 7% next year.

Times: Presumably you expect the stocks in your portfolio will post even better profit growth?

Collins: Small and mid-cap growth stocks’ [earnings] are starting to outpace the large companies. We’re of the opinion that large stocks will continue to move up, but not at the rate they have been rising over the past three years. We think small and mid-cap growth companies are playing catch-up right now. Given their superior earnings outlook and the low valuations placed on small and mid-cap growth stocks, we expect to see them go much higher than the large companies over the next four quarters.

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Profile

Name: Jim Collins

Business: Publisher of OTC Insight newsletter, money manager for individuals and operator of Dominion Insight Growth Fund mutual fund, each focusing on small companies and, to a lesser extent, medium-sized companies.

Services: OTC Insight, published monthly ($295 a year, [800] 955-9566); Dominion Insight Growth Fund, (3.5% load, [800] 880-1095; 5-year annualized return, 16.6%, compared with average mid-cap fund’s 16.9%).