Small--and Unloved--Stocks Have Big Potential
How can you tell small-cap stocks from large-cap stocks?
Small stocks are the ones with the better earnings.
Not that many investors have noticed, but profits of small companies as a group have consistently risen faster than those of large companies for the last three quarters--even though small companies’ stocks have lagged large stocks for much of that period.
And the profit gap is expected to widen noticeably when first-quarter data are reported over the next few weeks.
Analysts estimate that profits for companies in the Standard & Poor’s 500-stock index will rise only 0.8% in the first quarter versus a year earlier, according to earnings tracker First Call Corp. in Boston. That’s the lowest quarterly growth rate in more than six years.
On the flip side, earnings of companies in the Russell 2,000 index of smaller stocks are forecast to rise 10.7% in the quarter. Most important, they’re expected to hold that lead for some time.
“I don’t know if it’s going to widen much further from here, but it’s certainly not going to contract,” said Chuck Hill, First Call’s research director.
The Asia crisis gets most, though not all, of the blame for the sudden earnings woes of larger stocks, which of course include many multinationals. Weakness in the region has prompted a number of companies to warn that profits will fall shy of forecasts.
Other large companies, however, have blamed industry-specific trends for their expected profits shortfalls. Intel and Compaq fall into the latter category.
By contrast, small-cap companies’ earnings should hold up because the companies are far less exposed to Asia and much more dependent on the U.S. economy, which has remained vibrant.
“Who’s more likely to stub their toes” in Asia? asked Satya Pradhuman, small-cap research director at Merrill Lynch. “We think it’s the large companies.”
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There’s other good news for small-cap stocks. For the last three quarters, a greater percentage of small companies than large ones have “significantly” beaten analysts’ earnings estimates, Pradhuman said. Companies with such positive surprises are often rewarded with higher stock prices.
In the fourth quarter of 1997, 32% of small companies had significant positive earnings surprises compared with 20% for large companies, Pradhuman said.
The earnings worries of larger stocks, though, haven’t slowed the progress of blue-chip stock indexes such as the S&P; 500 and the Dow Jones industrial average. In the quarter through Monday, the S&P; was up 12.7% while the Dow tacked on better than 11%.
By contrast, the Russell 2,000 index of smaller stocks has lagged, with a 9% year-to-date gain.
Last year the S&P; index jumped 31% while the Russell rose 20.5%.
For the moment, at least, Wall Street thinks large-cap companies’ profits will rebound in the second half of 1998. For the year, S&P; profits are projected to advance 9.8%, according to consensus Wall Street estimates.
So what? ask small stocks’ proponents. The Russell 2,000 companies’ earnings are expected to balloon 24.5% for the full year.
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For investors who believe that small- and mid-sized companies’ earnings will be as good as expected--and that their stock prices may finally begin to reflect that--this is a good time to be shopping for potential winners, analysts say.
The chart accompanying this story, compiled with the help of First Call, gives a random sampling of small- and mid-sized companies in the Russell 2,000 whose earnings are expected to grow strongly in the first quarter.
It’s important to keep in mind that a huge projected jump in quarterly earnings is not in itself a sufficient reason to buy a stock.
A high quarterly growth figure could mean that year-ago earnings were abnormally low. In such a case, a company’s absolute profit could be weak even though the percentage gain is high.
Similarly, the earnings-per-share gain of a tiny company with relatively few shares outstanding could be misleading.
If a company earns 2 cents a share this quarter versus 1 cent in the year-ago period, its gain is 100%. But earning only a few cents per share is a hallmark of small and unproven companies with highly volatile profits.
To weed out such names from the accompanying chart, The Times asked First Call to limit the list to companies meeting certain criteria:
* Earnings must be projected by the analysts following the company to grow solidly in the next five years.
* The company must have been profitable in the past five years (or for as long as it has been publicly traded).
* The projected first-quarter increase in earnings, in absolute dollars, must be at least $3 million.
* At least three analysts must follow the company.
First Call generated more than 100 names with its screens, from which The Times selected 30 to show as a representative sampling.
Here are profiles of five of the companies:
Airborne Freight
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There’s more to overnight delivery than FDX Corp. and United Parcel Service.
Airborne Freight, which focuses on large-volume commercial customers, has done a good job sticking to its niche and not taking on the much larger FDX (formerly Federal Express) in every market segment. The strategy lets Airborne “charge dramatically lower prices,” said Paul Schlesinger, an analyst at Donaldson, Lufkin & Jenrette Securities Corp.
In part because of stumbles at its two competitors, Seattle-based Airborne Freight had a great year in 1997 and should turn in another solid performance this year, Schlesinger said.
Riding the crest of a strong economy, FDX raised prices last year. But the real beneficiary was Airborne, which was able to pick up market share, Schlesinger said. Likewise, the UPS strike helped Airborne add customers.
“They’re an effective competitor to Federal and UPS,” Schlesinger said. “Right now, their growth is faster and their domestic margins are better.”
The risk in Airborne is that it can get squeezed if FDX launches a price war. That’s a big reason profits were down substantially in 1995 and ’96.
Gentex
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Have you ever been momentarily blinded when the car driving behind you at night has its high beams on? How about when the sun is bouncing off your rearview mirror on a bright day?
Zeeland, Mich.-based Gentex makes electrochromic rearview mirrors that automatically dim when they catch a bright light. The technology is now installed in some luxury cars, such as the Buick Park Avenue, and high-end sport-utility vehicles, such as the Ford Explorer, said Steve Latham, an analyst at GS2 Securities in Milwaukee.
Latham likens the technology to cruise control, which initially was thought of as a luxury item but slowly caught on with car buyers at other levels. “Most consumers just aren’t aware that this exists,” Latham said. “Most people I talk to, once they get used to it, don’t want to buy a vehicle without it.”
Gentex has only 5% of the worldwide rearview mirror market and has plenty of room to grow, he said. The company has models with temperature gauges and other features that have high profit margins.
Overseas, the company is working on a side-view mirror that not only adjusts to light but also eliminates the blind spot, Latham said.
Mastech
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Imagine a business in which there are more than enough customers who want to buy your service.
Mastech and other firms in the information-technology staffing field are in that enviable position. Mastech supplies software engineers to companies for computer jobs ranging from year 2000 work to installing database software. Not surprisingly, there’s a huge demand for such services.
Mastech’s problem is it has a hard time recruiting enough workers to fill all the jobs.
To solve that, Mastech recruits heavily overseas, securing visas for highly trained foreigners to come to the U.S. The only roadblock to the strategy is the cap the federal government places on the number of visas that can be handed out.
To get around that, Mastech is developing operations overseas. It already has one facility in India and is putting two more into operation. These facilities can handle work for U.S. companies that does not have to be done on-site. That way, Mastech doesn’t have to bring workers into the United States. The foreign sites also handle work for Mastech’s growing international business, which made up 18% of revenue in the fourth quarter, from nothing in 1995.
The stock has been on a bit of a roller-coaster ride lately. It almost doubled from $30.25 at year-end to $59 on March 16. It then tumbled $15 in less than two weeks by Friday before leaping $5 on Monday.
The exodus of momentum investors may explain part of the sell-off. There also are questions about whether the federal government will raise the cap on how many tech professionals can come to the U.S.
“The fundamentals of the industry and the company-specific fundamentals are very positive,” said David Grossman, an analyst at Nationsbanc Montgomery Securities. “The only black cloud is the overhang of what may happen” with the visa issue.
Pier One Imports
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Low mortgage rates have helped home builders and lenders. They’ve also been a boon for related companies such as Pier One Imports.
The company sells a range of furniture and home furnishings. Pier One’s same-store sales have risen for 29 consecutive quarters, a significant accomplishment, said David Rose, an analyst at Jefferies & Co.
Fort Worth-based Pier One has done a good job of selling slightly more expensive goods that carry relatively high profit margins while keeping its wares affordable, Rose said.
The only downside to the stock is that it’s already had a big move, Rose said. From the end of 1996 through the middle of this month, it almost tripled in price. It’s given in to some profit-taking in the last two weeks.
“It’s got great management and great product offerings,” Rose said. “From the standpoint of the company, it’s doing everything right. From an investor’s standpoint, the risk is what the economy does and the company’s [continuing] ability to roll out those substantial increases in same-store sales.”
Total Renal Care
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Torrance-based Total Renal Care, one of the largest providers of dialysis services in the country, is on a tear.
The company recently bought rival Renal Treatment Centers, and analysts expect more acquisitions.
Total Renal has completed its purchases without denting its earnings or running into the unexpected problems that can crop up in mergers.
“They’ve done it without a hiccup,” said Robert Lunbeck, an analyst at Hambrecht & Quist.
The number of patients on dialysis is growing 7% to 10% a year, said John Hindelong, an analyst at Donaldson, Lufkin & Jenrette.
Along with the related medical services that Total Renal sells them, its same-store sales are growing 10% to 13% a year, Hindelong said.
The company is expanding about 12% annually through acquisitions, or about 25% combined. With a market share of less than 15%, there’s plenty of room for acquisitions, Hindelong said.
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For Profit Growth, Smaller Is Better
Even as profit growth tapers off at large multinational companies, many smaller companies are notching strong profit gains. Below is a sampling of mostly small and mid-size companies that are expected to report sharp gains in first-quarter earnings per share (EPS) and which also have solid long-term growth prospects, according to Wall Street’s projections of the companies’ five-year annualized EPS growth rates. Each company is covered by at least three analysts and has been profitable in each of the last five years, or for as long as it has been publicly traded. The P/E is the stock’s current price-to-earnings ratio based on Wall Street’s consensus estimate of 1998 earnings per share.
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1st qtr. 5-year P/E Ticker Mon. est. EPS est. EPS on est. Company: symbol close growth growth ’98 EPS Best Buy BBY $66.19 535% 17% 33 Vanstar VST 12.20 500 20 15 Arterial Vascular Eng. AVEI 38.56 425 40 36 Robotic Vision Systems ROBV 11.31 325 30 16 Neomagic NMGC 17.25 257 33 16 Credence Systems CMOS 26.44 213 25 13 P-Com PCMS 20.38 200 35 29 Input/Output IO 23.50 143 20 19 Mastech MAST 49.00 118 35 47 Allied Waste Industries AWIN 24.38 113 25 27 International Multifoods IMC 29.56 111 20 24 Citrix Systems CTXS 53.25 100 40 36 Physicians Sales & Svcs PSSI 23.00 100 30 35 Silicon Valley Group SVGI 19.13 100 22 23 National Oilwell NOI 32.81 95 20 19 Imperial Bancorp IMP 31.88 90 25 20 Varco International VRC 27.13 83 34 24 Hexcel HXL 27.38 68 25 17 Cognex CGNX 21.44 67 30 20 Total Renal Care TRL 32.29 59 28 26 Gentex GNTX 33.25 57 23 26 Snyder Communications SNC 47.25 55 45 56 Global Industries GLBL 20.53 50 35 32 Airborne Freight ABF 35.00 45 11 14 Ethan Allen Interiors ETH 62.94 41 15 26 Nationwide Finl Svce NFS 43.31 37 16 19 CKE Restaurants CKR 37.56 32 35 24 Hartford Life HLI 46.75 32 16 18 Pier One Imports PIR 28.00 24 20 30 Oakwood Homes OH 37.50 21 18 18
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Sources: First Call Corp., Bloomberg News
