Tech Surge Obscures Small-Cap Bargains

The U.S. stock market seems to be a story of two constants as the decade ends: Technology stocks keep getting more expensive; and small- and mid-size stocks keep getting cheaper.

The continuing surge in leading tech shares, and investors’ general fascination with everything tech, is obscuring what many Wall Street pros say are extraordinary bargains among ignored small- and mid-size companies.

The problem: It’s been that way for so long that many investors, understandably, figure there’s little hope of a dramatic comeback soon for the depressed smaller shares.

“If anyone cares . . . small-cap relative valuation measures have established new lows,” Steven DeSanctis, a Prudential Securities analyst, wrote in a recent report--summing up the frustration small-stock analysts have felt for much of the last few years.

But with January on the horizon, history gives a reason to hold out at least some chance for a snap-back in some smaller stocks.

Depressed small- and mid-size stocks often get more so toward year-end as investors sell their losers to record tax losses.

That can then set the stocks up for a rebound in January, as the tax-related selling ends.

This is the so-called January effect. Until this decade, it used to pan out much of the time. Smaller stocks were simply expected to beat bigger stocks in any January rally.

But in recent years, as veteran investors know, the January effect has been a no-show. That is, either smaller stocks have rebounded before January--more like in late-November and in December--or whatever January bounce has occurred has paled next to the continued gains in blue-chip stocks.

What’s more, DeSanctis noted that the underperformance of smaller stocks each January for the past six years has foreshadowed their underperformance (relative to larger stocks) for the ensuing year.

It’s not that smaller stocks, as measured by the Russell 2,000 index, haven’t risen over the last six years. But the 99% return on the Russell index in the six years ended Oct. 31 was light years behind the 240% total return on the blue-chip Standard & Poor’s 500 index.

Year to date the Russell index is up 10.4%, while the S&P; has risen 15.8%, not counting dividends. The tech-heavy Nasdaq composite has rocketed 61.7%.

This is a market in which investors have no qualms about paying high price-to-earnings ratios for stocks--as long as they figure the stocks will continue to rise.

Meanwhile, stocks selling for low P/E ratios attract little interest. Classic bargain-hunting has simply gone out of style in a big way on Wall Street and on Main Street.

So why think investors might begin to bottom-fish now, if they haven’t been interested in doing so for much of the 1990s?

DeSanctis can only rely on history: At some point, he says, investors should begin to care about finding bargains as opposed to merely chasing what’s already hot.

Measuring four other six-year streaks of sub-par returns for smaller stocks in this century, DeSanctis found that “in three of the four years following these periods, the small caps came back to beat the large caps.”

That still isn’t any guarantee, of course. Nonetheless, the accompanying chart lists 15 depressed smaller stocks that DeSanctis believes could be good candidates to lead a January bounce.

All of the stocks sell for low price-to-earnings ratios compared with the blue chip S&P; 500, which is priced at about 25 to 27 times estimated 2000 earnings, depending on whose estimate you use.

Note, however, that the low P/E ratios may well indicate that investors’ earnings growth expectations for the companies are modest, or that the companies may face significant competitive issues in their industries.

Still, for bargain-hunters--if there are any left in this market--the list may be an interesting place to start.

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Another way to approach the depressed small-stock issue: Buy what the insiders are buying.

Executives at small companies including CKE Restaurants Inc. and Pediatrix Medical Group Inc. are taking advantage of declines in their stock prices to buy shares--and that may signal other investors to do the same.

Among the last reported insider trades of the 20 worst-performing stocks in the Standard & Poor’s 600 Small Cap index over the last three months, including those of CKE Restaurants and Pediatrix, 10 were buys while only four were sells. There were no insider trades in the other six during that time.

The buying “means these stocks look awfully cheap and they are turnaround situations,” said Courtney Smith, chief strategist at the Orbitex Group of Funds, which oversees $1.2 billion.

Investors believe directors and other officers should have the best insight into their companies’ potential profits, and if those officials see value in a stock that has slumped as much as 80% this year, that could be a big reason to buy.

Checking the last insider trades of the 20 worst-performing S&P; small-cap stocks in the same time period last year shows that investors would have benefited if they had given these stocks a second look. Company officials purchased stocks on six occasions and sold on five, with an average gain of 18% in the six months after an insider buy.

Stocks to watch range from health-services companies to manufactured home firms to satellite makers. But note: Many of these are money-losing operations in need of a turnaround that may not be forthcoming.

Where insiders have bought:

* Pediatrix Medical director Michael Fernandez in October bought 16,000 shares in the company, which manages pediatric offices, bringing his holdings to 34,400.

“I see the company as undervalued in the marketplace, and if the opportunity presents itself I will continue to buy,” said Fernandez, who said he had bought Pediatrix stock valued at up to $500,000 in the last six months.

The stock (ticker symbol: PDX; Monday close, $7.50) has declined 88% this year as revenue growth has slowed.

* Byron Allumbaugh, a director of CKE Restaurants (CKR, $6), parent of Carl’s Jr., the No. 4 burger chain, bought 20,000 shares on Oct. 1 for which he paid $6.75.

* Edwin French, chief operating officer of US Oncology Inc. (USON, $4.78), bought 10,000 shares in the manager of cancer treatment centers, bringing his holdings to 18,460, on Oct. 29.

* Daniel Fink, a director of Orbital Sciences Corp. (ORB, $14.06), the biggest U.S. maker of small satellites, bought 200 shares on Sept. 17, bringing his holdings to 12,334.

* Archie Lennon, a director of Delta Woodside Industries Inc. (DLW, $1.88), the maker of Duck Head brand men’s clothing, bought 3,195 shares on Oct. 5, bringing his stake to 15,485.

* Kermit Phillips, an Oakwood Homes Corp. (OH, $2.81) director, picked up 29,300 shares of the largest U.S. retailer of manufactured homes in September, raising his holdings to 281,000.

* Gerard Moufflet, a director of Curative Health Services Inc. (CURE, $6.94), bought 4,000 shares of the wound-treatment centers company in September, a 40% increase in his holdings.

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Due for a January Bounce?

Prudential Securities analyst Steven DeSanctis says the depressed shares of these small-capitalization companies may be poised to bounce back in January, if investors go value hunting--as they historically have often done in the small-stock arena at the start of the year.

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Ticker 52-week Monday Pct. 2000 Stock symbol high close drop P/E* Lason Inc. LSON $68.25 $24.25 -64% 12 Hanger Orthopedic HGR 27.50 10.25 -63 10 Buckle Inc. BKE 32.56 13.75 -58 9 Sonic Automotive SAH 18.94 8.50 -55 6 Stein Mart SMRT 12.00 5.75 -52 8 Shopko Stores SKO 40.75 21.63 -47 8 Musicland Stores MLG 15.50 8.38 -46 5 Oakley OO 9.88 5.63 -43 14 Alliant Techsystem ATK 88.00 53.81 -39 8 Boston Beer SAM 11.13 7.13 -36 13 Tetra Tech WATR 22.38 14.63 -35 17 Jacobs Engineering JEC 42.75 30.38 -29 11 Lamson & Sessions LMS 6.94 5.13 -26 6 Hovnanian Enter. HOV 8.50 6.31 -26 4 XTRA Corp. XTR 47.81 42.38 -11 1

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* Stock price-to-earnings ratio based on estimated earnings per share for the next 12 months.

Source: Prudential Securities