HOT GROWTH COMPANIES
Fore Systems Inc. was the quintessential risky startup. With just $100,000 from savings, four researchers from Carnegie Mellon University launched the company five years ago based on a simple notion: The high-speed networking switches being developed for telephone companies could also be used to up the capacity of smaller computer networks that link workstations and PCs. "Our biggest concern," recalls Chairman and CEO Eric C. Cooper, 36, "was why wasn't anyone else doing it?"
While others were on the sidelines, Fore Systems used the new technology, called asynchronous transfer mode (ATM), to build a big lead in the market for switches and the accompanying software that help run high-speed, flexible local-area networks. With networked computing taking off, revenues for the fiscal year ended March more than tripled, to $75.6 million. Profits were up over 250%, to $7.4 million.
TEAMWORK. Its mix of top-flight growth in sales and earnings plus torrid return on capital helped land Fore Systems the No.4 spot on BUSINESS WEEK's Hot Growth list. Fore has more than 60% of the $100 million market for ATM switches. But Cooper and his band of techies will have to fight hard to stay on top: Rivals such as Cisco Systems Inc. and 3Com Corp. are gearing up to take a bigger share as ATM edges out the old Ethernet technology for local networks. To meet the challenge, Fore is rolling out new switches that can transmit data ever faster, while tackling new markets through deals with big players such as Northern Telecom Inc. "There are more people entering their market," says Needham & Co. analyst G. Arjavalingam. "But it's clear Fore will be the dominant supplier of this technology for at least the next few years."
Quick. Opportunistic. Creative. Those are the traits linking the companies on BUSINESS WEEK's 1995 Hot Growth list. Like Fore Systems, the 99 other companies have outpaced far heftier rivals by getting there first and doing things better. Even as 1994's strong economy gave Corporate America its most sizzling year in a decade, these tiny dynamos continued to race to the head of the pack. Over the past three years, sales for the companies on the list grew an average of 66%, compared with 5% for the Standard & Poor's industrials index. Earnings jumped 164%, compared with the S&P's 27%, while return on invested capital hit 30%, against 10%.
Fore Systems isn't the only Hot Growth company capitalizing on technology. As personal computer sales boom, demand for wireless and other telecommunications technology soars, and computers spread to every business, 25 of the 100 companies on the list were software- or computer-related, while five were in telecommunications. "More technology companies were meeting or exceeding earnings estimates than I've seen in years," says Jack LaPorte, portfolio manager of the T. Rowe Price New Horizons Fund, a small-company mutual fund.
Like Fore, companies that successfully tapped into the shift to networked computing were particularly hot. NetManage Inc. (No.15) develops programs that run local-area networks. Cambridge Technology Partners Inc. (No.12) helps companies design large-scale integrated computer systems. Plenty of profitable prospecting is also being done in health care. Employee Solutions Inc. (No.9) helps small companies lower health-care and workers' compensation costs by bundling their staffs together to negotiate rates with insurers and managed-care providers. Growing fears of transmittable diseases helped Safeskin Corp. (No.10) boost sales of its specialized latex medical gloves by 70.2% annually since 1991.
Of course, plenty of companies made the list by mining un-techie veins. Despite a rather tough retail climate, Urban Outfitters Inc. (No.76) carved out a lucrative perch by catering to the unglamorous fashion tastes of Generation Xers. And the No.1 spot goes to Happiness Express Inc., a New York-based toymaker that scored big with kids' accessories based on TV characters such as the Mighty Morphin Power Rangers.
COOL MARKET. Much of the fuel for growth last year came from a booming economy. Some saw sales explode thanks to the healthy growth of big corporate customers, while others created robust demand carving out new niches ahead of big rivals. Can they keep it up? A slowing economy may make it hard for some small companies to sustain heady growth. "It's going to be a much tougher environment," warns LaPorte.
Wall Street has already soured on some small-company stocks. Even Hot Growth companies that delivered eye-popping results last year often trailed bigger brethren in the market. Shares of stocks on this year's list are currently trading at an average of 16% below their 52-week highs, while the average S&P industrial stock is trading at 8.9% below its 52-week high. The reason: For much of 1994, investors favored big cyclicals as the surging U.S. economy fueled robust earnings for auto makers, chemical producers, and the like. "The wind was clearly in our face," says James P. Goff, portfolio manager of the $1.5 billion Janus Venture Fund, a growth company fund.
That stiff breeze also cooled initial public offerings. After setting a fiery pace in 1993 with more than $57 billion raised, new public companies raised just $34 billion in 1994. In 1995's first quarter, less than $4 billion in equity has been sold through IPOs. Analysts say that reflects the general swing toward big-cap stocks, though as the market heats up, some expect IPOs to do likewise. Start-up funds still abound: According to Venture Capital Journal, $3.8 billion in venture capital was raised in 1994, up from $2.5 billion in 1993.
And last year's ill wind may yet blow investors some good. T. Rowe Price's LaPorte believes that many small companies are selling at bargain prices. LaPorte measures the richness of small-cap stocks by comparing the average price-to-earnings ratio of the stocks in his portfolio with the p-e ratio of the S&P 500. Today, LaPorte's stocks are trading in the lower half of their historical range relative to larger-company stocks. That, he says, leaves plenty of room for an upturn.
Indeed, small companies able to dodge the slowing economy may soon be back in vogue. For one thing, a slowdown in growth will first hurt the earnings of the cyclical businesses that the market has favored. And if Congress does pass a capital-gains tax cut, growth stocks stand to be big beneficiaries. "The flow of funds in the market is rushing back to growth," says Robert E. Stansky, portfolio manager of the $3.7 billion Fidelity Growth Company Fund. "Money is moving out of cyclicals and into fast-growing small companies."
Of course, these fleet-footed little racers always run the risk of stumbling (page 80). Some could prove too dependent on one or two products or customers and get tripped up by changing tastes or shifting markets. Others, cautiously threading their way among the elephants, may get squished. But the smart, the lucky, and the swift on BUSINESS WEEK's Hot Growth list stand a good chance of outmaneuvering the titans today--and joining their ranks tomorrow.By Amy Barrett in Washington