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To Some, Small Is Beautiful

There might be more unpleasantness to come in the stock market because of weak corporate earnings, but there are "pockets of good value," says James W. Oberweis, president of Oberweis Securities and an expert picker of micro-cap, small-cap and mid-cap stocks.

The area he emphasizes now is micro-caps -- companies with market capitalization of $150 million or less. Small- and mid-cap stocks still look good relative to the large-caps ($5 billion and above), but micro-caps "didn't really have a turn in the limelight until this year," Oberweis says.

Among the micro stocks he likes are SFBC International, which does research for pharmaceutical and biotech companies, and Ramsay Youth Services, which focuses on programs for troubled young people. Although Oberweis is highest on micro-caps these days, he recommends diversifying with small- and mid-caps as well. He predicts that investors who buy a diversified portfolio of such stocks "will hit a few big winners," though he admits he can't tell which of his aggressive growth choices will be the next Microsoft, Cisco or McDonald's.

These were among the points Oberweis made in a chat presented Nov. 1 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online and Margaret Popper, BW associate economics editor. Following are edited excerpts from this chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: The market did better today -- it seems to be reacting moment to moment to the news. Do you see any clear trend?

A: The market always reacts moment to moment to the news; that's what capitalism is all about. Clearly, the past month we've been in an upward trend following the decline in mid-September. But the weak earnings reports have indicated that there might be more unpleasantness to come.

Q: Can we trust the stock market rally since Sept. 21?

A: Well, what I would answer is that we are now trading by most indexes at a level higher than the pre-attack levels. Even after a rapid decline in most of 2001, the S&P 500 average p-e multiple is trading at the high end of historical norms. So in some ways, no, but there are pockets of good values -- in particular, micro-cap growth stocks.

Q: Which industries will lead the market up?

A: In the short run, the medical-related industries seem to have a great degree of resiliency to the effects of a sharp recession, as opposed to other areas such as technology. Most of our successful names in the past six months have tended to lie in medical-related fields. That said, p-e's are generally higher in this sector as well, but at this point in time, we think the quality of earnings is worth paying for.

Q: What are some of the micro-cap growth stocks you like?

A: We like a company called SFBC International (SFCC), which is a contract-research organization that provides pharmaceutical and biotech companies with research services. The company has been growing sales at a rate greater than 70% in the last 12 months. It has a market cap of about $89 million.

Even smaller, we like a company called Ramsay Youth Services (RYOU) -- a provider of education, treatment and community-building programs for troubled youth. They're growing at a rate of 35% and trading at a very reasonable p-e ratio. Lastly, we like a small pharmaceutical management benefit company called MIM Corp. (MIMS). And one more: an American company that imports beer and other beverages into Poland -- Central European Distribution (CEDC).

Q: Anything in the telecom area?

A: Right now, we see very limited opportunities in the telecom sector. Although this area was a growth industry during most of the '90s, problems with overcapacity have made it very difficult for companies in that area to grow at rapid rates. One exception that we like is Catapult Communications (CATT). Catapult develops testing software for the telecom market.

Q: You've mentioned one medical company -- are there any names you follow whose business might relate to the anthrax scare?

A: Sure. One company that we own in funds is called Meridian Medical Technology (MTEC), and interestingly they have two businesses. One of the businesses is involved in the development of prefilled automatic injecting syringes. In fact, they are the exclusive provider to the U.S. Army of such automatic injectors. The U.S. Defense Dept. last year was about 27% of their sales.

Q: One of the problems with investing in micro-caps is that their stories aren't well known, and analysts don't cover them. Where can investors get information on this sector?

A: The Internet has changed an awful lot about the way people receive information about public companies. Any investor with a computer can use a company's own Web site and public Web sites that carry SEC filings and uncover a wealth of information about almost any company.... At Oberweis, we use automated databases to help us through the process, but years ago we would just page through the newspaper, watch earnings reports and look for companies growing at rates greater than 30%. An individual investor with the time can essentially use this same process today.

Q: Any thoughts on a company called PEC Solutions (PECS)?

A: PEC Solutions is a company we own in our portfolios. It is on our "top 20 companies to buy now" list. PEC Solutions helps government agencies capitalize on the Internet by migrating paper-and-pencil procedures to Web-enabled processes. We expect that one of the side effects of September 11 will be an increased expenditure by the U.S. government on technology, and PEC stands to benefit from that. Even in the absence of those effects, PEC has been doing extraordinarily well.

Q: Any low-priced oil drillers look good?

A: One company that we own, which isn't necessarily low-priced in terms of real dollar value per share but has only a $220 million market cap, is Key Production (KP). Its low valuation relative to earnings makes it attractive to us. Another smaller petroleum-related company is PetroQuest Energy (PQUE). We also like Prima Energy (PENG), and upon a dip or correction would add Remington Oil & Gas (ROIL). In the natural-gas area, we like Hanover Compressor (HC).

Q: With the way airline, hotel and other travel-related stocks have plummeted since September 11, what former large-cap stocks (if any) have you been watching?

A: Not really too many, because we're an aggressive-growth manager. Many of the travel-related companies that have declined to be smaller companies would fit more in a value portfolio than a growth portfolio. However, I am very interested in watching the progress of the online discounters like Expedia (EXPE), which reported still quite good numbers for the September quarter, even in light of the September 11 tragedy. The challenge will be the December quarter.

Q: Just to clarify for all of us, Jim, what market caps apply to your definition of micro-, small-, and mid-caps?

A: At the time of acquisition, micro-caps are defined as companies with $150 million or less in market capitalization. Small-caps are defined by us to be those companies with market caps between $150 million and $1 billion. Mid-caps include those companies with market caps between $1 billion and $5 billion.

Q: Are there any hot stocks to buy that are under $10?

A: Sure. We like Central European Distribution, which is at $8.50; Ramsay, which we mentioned earlier, and Biolase Technology (BLTI) at $5.04. At a little more than $10 we like Verisity (VRST), which designs software that verifies the functionality of integrated circuits. They seem to be gaining market share from competitors like IKOS, Cadence (CDN), etc.

Q: Jim, I wonder if low price is a good criterion for a stock buy -- isn't good value a better yardstick?

A: I think low price is a completely irrelevant measure, and it makes absolutely no difference to me whether a stock is $5, $10 or $100. What I focus on is the company's earnings prospects in relation to my estimated rate of growth for them.

Q: What do you think of Genesis Microchip (GNSS)?

A: We were early investors in Genesis, in 1998, and we were probably too early. It has taken a little while for the flat-panel area to really gain momentum. It really looks now like we sold too early, and in fact have seriously thought in recent times about going back in. This is a good area for the next five years, and Genesis is among the leaders. They make integrated circuits for flat-panel computer monitors.

Q: At the outset, you told us how high you were on micro-caps. Have the small-cap and mid-cap sectors lost some of the luster they had?

A: No, I think the small- and mid-cap sectors, relative to large-cap, continue to be very attractive. However, these things tend to go in cycles. In 1998 and 1999, large-caps had their day in the sun. In 1999, mid-caps had a phenomenal second half. For example, our mid-cap fund was up 113% in 1999. The micro-caps, however, didn't really have a turn in the limelight until this year. As it frequently takes some time for those cycles to shift, I would focus attention on the micro-cap area, but it does make sense to diversify across all of these asset classes.

Q: You mentioned a top 20 list earlier -- care to share it?

A: Sure. Amarin Corp (AMRN), AdvancePCS (ADVP), Bradley Pharmaceuticals (BPRX), Chico's FAS (CHS), LabOne (LABS), PEC Solutions (PECS), Petroquest Energy (PQUE), Sunrise Assisted Living (SRZ), DrugMax (DMAX), Central European Distribution (CEDC), Catapult Communications (CATT), Cytyc (CYTC), Hanover Compressor (HC), Biolase Technology (BLTI), Verisity (VRST), Cabot Microelectronics (CCMP), Shaw Group (SGR), MIM Corp. (MIMS) and maybe Caminus Corp. (CAMZ).

Q: Can you tell us a few of your current favorites among the small- and mid-caps that you haven't already named?

A: We like a pharmaceutical company out of Israel called Tero Pharmaceutical, which is growing sales at a rate of about 50%. We recently began acquiring shares in fast-food restaurant chain Sonic (SONC), and we have a position in Right Management Consultants (RMCI), which helps corporations with layoffs and downsizing. And we just bought a position -- today, in fact -- in our mid-cap fund in Charles River Laboratories (CRL), which sells, among other things, experiment-quality rats to biotech companies.

Q: Thinking of today's giants that were once small-caps, do you see any potential giants that we could get an early start with among the stocks you watch?

A: Sure. All of them. We buy companies with a unique competitive product. Unfortunately, even after hours of diligent research, we're not able to conclude which of the companies in our portfolio will be the next Cisco, Microsoft or McDonald's. However, we've done this a long time, and we know that with statistical regularity, investors who buy a diversified portfolio of companies that fit our criteria will hit a few big winners. And a few of those big winners can go a long way.

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