Smaller stocks are the place to be, in the view of James W. Oberweis, president of Oberweis Securities, which has mutual funds specializing in micro-, small-, and mid-cap stocks.
He points out that the Russell 2000 index of small-cap stocks has outperformed the S&P 500 by 15% over the last 18 months and that valuations are better among the smaller issues. Although he is unwilling to predict an early upturn for the market as a whole, Oberweis thinks smaller-company stocks look good -- not just because of their more favorable valuations, but also because of recent cuts in interest rates and taxes, which he says tend to be of more benefit to smaller companies.
Some of Oberweis' recent buys include Hotel Reservations Network, Bradley Pharmaceuticals, and ACLN Limited. He also sees hope for selected technology stocks and cites names such as Actrade Financial Technologies and FTD.com.
Oberweis made these comments in a chat presented July 26 by BusinessWeek Online on America Online. He was responding to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from the chat follow. A full transcript is available on AOL at keyword: BW Talk.
Q: Jim, how high are your hopes for the promised second-half turnaround in the stock market?
A: I don't think that it can be taken for granted that the market will rebound anytime soon. I believe that valuations are currently fair but not inexpensive. However, within the market, I believe there are pockets that continue to be extraordinarily undervalued. In 1997 and 1998, small-company stocks were widely ignored, while large-company stocks were touted by everyone. This led to dismal performance by small-company stocks, if one measures such performance by the returns of the most widely followed small-cap benchmark, namely the Russell 2000.
In the past 18 months, that situation has somewhat been remedied -- in that same period the Russell 2000 has outperformed the S&P 500 by approximately 15%. So it looks like we're headed in the right direction for small-cap stocks. I don't profess that I can tell you what the overall market will do in the next 15 months, but if I were to bet my chips, I'd put them on smaller-company stocks.
Q: Jim, do you think small caps will continue to beat large-cap stocks -- and why?
A: Yes. I think there are a number of reasons. First, valuations, to us, appear significantly more attractive for small-cap stocks than for large-cap stocks.... Interestingly, the expected growth rate in earnings for small-company stocks is significantly higher than the expected growth rate in earnings for large-company stocks.
Secondly, monetary and fiscal policy is trending in a direction that has historically been very favorable for smaller-company stocks.... Historically, a declining-interest-rate environment has been favorable for stocks of all market categories, but particularly favorable for small companies.... Additionally, declining taxes tend to be a very favorable development for smaller companies.
One other point: The advent of the Internet will offer a multitude of new opportunities for smaller companies to compete with larger companies in ways that never would have been possible in the past.
Q: Which sectors should benefit most?
A: We are now entering the tail end of earnings season, and so far, we've seen some pretty ugly reports from tech companies, and we've seen outstanding reports from pharmaceutical and medical companies. That said, the valuations for technology companies have been reduced to the point where many of these companies are finally starting to look very attractive. We don't think that it's possible to effectively time sectors but instead prefer to focus on rapidly growing companies irrespective of the sector in which they conduct their business.
Q: Besides small and mid caps, Jim, you follow micro caps. What's your definition of a micro, and can you give us any interesting examples?
A: Sure. A micro cap, by our definition, is a company generally under $250 million in assets. In the Oberweis micro-cap portfolio, we attempt to acquire companies with market values under $100 million at the time we take an initial position. That means we are buying truly small companies.
As an example, we own a company called SFBC International (SFCC) that's involved in drug development research services. Many of the top 25 pharmaceutical companies contract with SFBC to help with drug discovery research. The company has a market capitalization of approximately $70 million and a growth rate greater than 30%.
Q: Care to state your funds' current top holdings?
A: We actually have three funds: a micro-cap fund, the Oberweis Emerging Growth Portfolio, and the Oberweis Mid-Cap Portfolio. I'll mention a few of our top holdings from each of those funds.
First, in the Oberweis Emerging Growth (our flagship fund), our largest holding is a company called AdvancePCS (ADVP), which provides pharmaceutical benefit management services to help benefit-plan sponsors and pharmaceutical manufacturers. Our second-largest holding is a company called Andrx (ADRX). Andrx provides oral drug delivery technology, and also has a portfolio of generic pharmaceuticals.... Our third-largest position is in retailer Chico's FAS (CHS), which retails upscale clothing to women aged 35 to 60.
In micro caps, our largest positions include Suprema Specialties (CHEZ), Headwaters (HDWR), and Gentner Communications (GTNR). Suprema is a provider of wholesale cheese products, which we originally acquired at about $8 and which has since appreciated to over $15.... Headwaters is a developer of alternative fuel products made from primarily residual coal waste.... Lastly, Gentner makes communications products and conference systems for high-end corporate installations. We're not only an investor, but we're also a customer.
In the mid-cap area, we like Cytyc (CYTC), which developed an innovative new test for cervical cancer that is rapidly replacing the traditional Pap smear. In the past four years, the company has grabbed 46% of the U.S. Pap smear market. We believe they will surpass 50% in the next three months.
Q: Can you mention any of your recent buys?
A: Sure. In the mid-cap area, we've been acquiring shares in Hotel Reservations Network (ROOM), which offers leisure travelers discounted rates on hotel rooms.... In our smaller-cap funds, we've been acquiring shares in Bradley Pharmaceuticals (BPRX). The company acquires smaller drugs from huge pharmaceutical companies and increases marketing levels to drive sales growth. We've also been increasing our position in a company named ACLN Limited (ASW), which is a shipping and marine logistics company.
Q: Jim, can you tell us how your funds are performing?
A: There's a big disparity between the performance of the smaller funds compared to the performance of the mid-cap fund so far this year. Our micro-cap fund is having an excellent year. Through today, the fund is up 16%. The small-cap fund, which we call the Oberweis Emerging Growth Portfolio, is also positive for the year, with a gain of approximately 1% year to date. Our mid-cap fund is down approximately 29% this year, and it would be terrible, except that investors were rewarded with a 113% gain in that fund in 1999.
Q: How long do you think the small-cap run will last?
A: Historically, those cycles have lasted an average of five to seven years. Some of those cycles have been significantly longer.... Right now, we've seen approximately 18 to 24 months of small-cap outperformance, depending on when you start the clock. However, in no circumstance do I believe that this cycle is close to an end. Valuations in small companies are still low relative to other sectors of the market. Oftentimes, the final stage of the cycle results in massive speculation of investors bidding up prices on small-cap stocks, similar to the way they bid up valuations for large-company stocks in the late 1990s.
Q: Did your funds suffer when the dot-com bubble burst? And are there any Net or B2B [business-to-business] stocks you still like?
A: The answer is yes. Because we invest in growth companies, we tend to have a reasonable position in technology. However, unlike many other aggressive growth funds, we only buy profitable companies. That probably kept us out of a lot of trouble when the Internet mania collapsed. But, as an aggressive growth investor, I certainly could not say we went unaffected.
There are a number of companies at current valuations that we like in the Internet-related world. Specifically, we like a company called Actrade Financial Technologies (ACRT), which allows customers and suppliers to agree on electronic payment terms and settlement using Actrade's electronic trade acceptance draft program .... Another company that we like is FTD.com (EFTD). As you might guess from the name, this is the e-commerce subsidiary of a flower company we all know. The company is profitable and growing at a rate approaching 30% annually.
For those interested in a wide variety of smaller, growth-oriented companies, consider visiting our Web site at http://www.oberweis.net. Readers of this transcript are eligible for three free issues of the Oberweis Report. Just e-mail us from our Web site, and let us know you'd like three sample issues at no cost.
Q: Aside from the Net, what are a few of the tech stocks in your "reasonable position"?
A: We own shares in a recent IPO called Pemstar (PMTR), which provides electronic manufacturing services to original-equipment manufacturers in communications, computing, data storage, industrial, and medical equipment markets. We also have an investment in IntraNet Solutions (INRS), which provides content management solutions for e-commerce applications.
A new name for us is SpectraLink Corp (SLNK). They make wireless telephone systems for large office complexes and campus environments, so that individuals can answer their office phone calls irrespective of where they may physically be in the office environment....One last name: PEC Solutions (PECS) is a professional-services firm specializing in helping government organizations become Internet-enabled.