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Small Caps, Big Performers?

There's good potential in many small-cap shares, especially value stocks. So says Marcus W. Robins, editor-in-chief of The RedChip Review, which tracks the small caps

Robins thinks that the trend into large caps that lasted almost 20 years, until 2000, has reversed, and that small caps are starting to have their day again. At the moment, he considers sectors hard to pick and focuses on special situations. Among them are stocks in sensors (BEI Technologies, for one), machine tools (Excel Technologies and Electro Scientific Industries), and health care and life sciences (KV Pharmaceutical and Vivus, for instance).

He points particularly to the potential for companies that treat sexual dysfunction with medications that go beyond Viagra, which he says can't be used by or has no effect on 50% of the men in the possible market. Robins names Vivus as a company that's working on products to remedy this, as well as developing cures for sexual dysfunction in women and for premature ejaculation, which he describes as a bigger problem than impotence.

These were some of Robins' comments in a chat presented Jan. 17 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Amey Stone of BW Online (for more on Robins' investment strategy, see BW Online, 1/15/02, "From RedChip, 'Tomorrow's Blue Chips'?"). Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Marc, before we delve into small caps, what do you think of the tone of the current market overall? Will it struggle back above 10,000?

A: Oh, definitely. It's going to be a struggle -- that's exactly the right word.... We really liken the market in 2002, and possibly through 2007, to that of the mid to late '80s. For those of you who have forgotten, or maybe not experienced, the late '60s, '70s, and '80s, the market top blew off in '68 (at 1,000), bounced around 600, then blew back up to 1,000. Many major well-held companies of the time didn't see high prices until the late '90s and 2000. It was the secondary and tertiary stocks that really led the appreciation parade.... During this period of increasing inflation, poor corporate profits (as measured by the S&P), and increasing inefficiencies in major corporate operations, the small caps returned an eight-year performance that was almost 2:1 in returns (35% vs. 15%) compared with the large caps.

Q: How are small-cap stocks doing lately? Are they outperforming large caps this year so far?

A: Remarkably, the small-cap value stocks really started to perk up here in the third quarter.... Incidentally, we've seen a lot of secondary and tertiary growth names be a little better as well. Yesterday, when the Dow was off a couple of percent, and the Nasdaq gave back the whole year's gains, many of our stocks (almost all of them) may have retreated a touch, but they're still further ahead than they were in September -- and certainly since the beginning of the year.

Q: What's the potential for small-cap bank stocks in 2002, and what are some of your picks in that industry?

A: Small-cap banks, actually, from this point on out, ought to do pretty well. The first thing is the very positive yield curve.... The small-cap banks also don't have the foreign-loan exposure that some of the large-cap banks have (Chase, etc.). So loan quality in general has to be a lot better for the secondary banks.

As we come out of this recession and interest rates are low, the third thing that's going to be beneficial is fee income, as it pertains to new mortgage originations and refinancings. So really, you've got a very nice environment for the secondary banks. Names that we have liked include Texas Regional Bancshares (TRBS), UCBH Holdings (UCBH), Bank of the Cascades (CACB), and Northrim (NRIM), which is located in Alaska.

Q: What's your take on small pharma stocks?

A: We have had considerable success in a couple of areas regarding pharmaceuticals. Those that have FDA-approved drugs [but] have yet to hit their stride in the marketplace are more often than not a sure bet. Second, we love companies that have an established detail sales team and a management that understands how incremental product sales are greatly profitable. Third, we'll look at companies that are really public venture operations, but only if they have very good science, face tremendous markets, and...have little competition. One we like is KV Pharmaceutical (KV.B). We also like Vivus (VVUS).

Q: Marc, what impact is the swing in cash flows from one asset class to another having on the stocks you follow ?

A: I like to describe it as similar to the tides of the ocean.... Since 1982 until roughly 2000, you've had the tide going out of small caps and into large caps. I really think the reverse is going to happen. It's a very long-term, secular trend, and I think it has already begun to help improve the valuations of the secondary and tertiary stocks. An interesting statistic is that if just 1% of the pension funds that are allocated by consultants came out of large-cap stocks and were put into the RedChip 2000 [an index of 2,000 small-cap stocks], it would double or nearly triple the market valuations in smaller-cap stocks.

Q: What small-cap sectors look strongest for this year?

A: Sectors are really going to be difficult to pick. There doesn't seem to be any true leadership in specific sectors.... Individual and unusual names -- what used to be called special situations -- are really getting the attention and are really the ones that are performing.

That said, I still think there's a lot of opportunity in sensor companies.... I also think that we're going back to our long-term trend in health care. There just continues to be an ongoing stream of brilliant inventions and devices created that are going to improve the quality of life as our nation gets older. So that's an area that I continue to like. I also believe that machine-tool manufacturers are interesting as a segment. This is not the cutting-mill and metal-lathe area, but companies that specialize in tools for micro-machining or mass construction -- equipment that's going to be used for producing really miniature products. There are now several laser companies that I think have good long-term prospects.... I also like the opportunity of new specialty consumer brands.

Q: Can you give us any names in those promising areas you cited?

A: There are several sensor companies I like. BEI Technologies (BEIQ), Measurement Specialties (MSS), Duraswitch Industries (DSWT) are three names that come to the fore. I would like to make a comment, however, on Measurement. They did stub their toes in 2001, but that was after trying to cram way too many transactions, business purchases, and underwriting [situations] all into too short a period. I think there's some really great upside in that stock.

In the machine-tool area that I have spoken about, two high-quality names come to the fore. One is Excel Technology (XLTC), and the other is Electro Scientific Industries (ESIO).

In the life-sciences area, I like Vivus. Sexual dysfunction does not end with the popping of a Viagra pill. It's not very well known, but more than half the men who suffer from ED [erectile dysfunction] can't use or have no effect from Viagra. Right now, that's over $1.5 billion. Vivus has solutions not only for ED but has had tremendous success in its Phase II studies regarding sexual dysfunction in women, which probably is a $4 billion to $6 billion market.

Also, [Vivus] already has a product in development (and under study) for PE (premature ejaculation), which again is a larger market than male sexual dysfunction. So once you get beyond the fear of not investing in a major pharma and understand the opportunities in treating all forms of sexual dysfunction, Vivus makes for a very interesting investment. I also like Merit Medical (MMSI). We mentioned KV.B, and we also like Integra LifeSciences (IART) and have a rather broad list of other ideas.

Q: To amplify, is PE premature ejaculation? I know it's not price-earnings (p-e) in this case.

A: I think I'd better be safe with a very cautious answer and say you're right, it's not p-e ratio. And interestingly, although it's not talked about in society much, PE happens to be a malady which is larger than impotence, and it's a very serious problem with younger couples, particularly if they're wanting children.

A fascinating side about how society has changed ever since the introduction of Viagra is that men may never be willing to openly discuss their difficulties in having sex, but because it's so much more open, à la Senator Dole, women will actually drag men to see specialists regarding these "afflictions".

Q: Marc, you mentioned that investors need to "temper enthusiasm" in biotech. What about the rest of the market -- do you worry about current valuations?

A: I only worry about exogenous events, like another hijacking or bombing, that could challenge the market significantly. Otherwise, I believe that we will probably be facing a gradually upward-sloping market.

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