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Springtime for Small-Cap Growth Stocks

With the economy coming out of recession, it's a good time for small-cap growth stocks. So says Andrew Rich, co-portfolio manager of Driehaus Small Cap Recovery Growth Fund, who focuses on finding good stocks or funds and sticking with them, rather than trying to time the market.

The fund he manages is aimed at institutional investors and looks for stocks with a market capitalization of less than $1.5 billion that are trading at prices at least 30% below their historical highs -- and whose fundamentals are starting to improve. Right now, Rich finds consumer cyclicals to be a promising sector.

Among his favorites are PETsMART, the retailer of products for pets; Action Performance, which makes collectible NASCAR models; and Scientific Games, a producer of online lottery and parimutuel equipment. He also likes Lone Star Steakhouse and Sports Authority in the same general arena.

These were among the insights Rich shared in a live chat presented on Mar. 7 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Andy, what's your macro view of the stock market? Are we in a genuine uptrend that has legs?

A: I think we're at the beginning of an uptrend. However, it's hard to determine what kind of legs it has in the near term. It's probably going to be a choppy market for a while. But I think we'll work our way up. We'll probably have higher lows and higher highs on most days. But I definitely think we've seen the worst already.

Q: Can you briefly tell us what criteria you use to buy small-caps?

A: We are a growth investor. We look at market-cap ranges of less than $1.5 billion. We have a Driehaus Small Cap Recovery Growth Fund, which looks for stocks trading at least 30% below their historical high price. And these are often companies where sales and earnings have underperformed, and therefore their stocks have been weak. But we try to catch them as their fundamentals start to improve and their stock price starts to head back up.

Q: Do you look for small-caps to continue to outperform their bigger brethren?

A: I'm expecting small-cap stocks and in particular small-cap growth stocks to continue to outperform most other market caps and styles for probably the next year or two, considering we're coming out of a recession, when small-caps normally perform well.

Q: Why do small-caps do better than mid- and large-caps in a recovering


A: I think it has to do with just being a beneficiary of price-earnings multiple expansion to some degree. The rationale is not so clear-cut, I guess. But it often works out that way. I think mostly it's more growth vs. value that does better, and it's usually small-cap growth more than large-cap growth. I think people just gravitate toward growth stocks when the economy is looking stronger.

Q: What are your largest holdings and/or favorite stocks now?

A: A couple of the largest holdings are PETsMART (PETM), Action Performance (ATN), and Scientific Games (SGMS). PETsMART is obviously a retailer of pet supplies. We purchased it last summer as same-store sales began to accelerate and the company had been remodeling stores, which produced dramatic sales and productivity gains.

Action Performance is a stock we've owned for a long time. They make NASCAR die-cast collectibles. It has been a big winner. It's now at $42. NASCAR's popularity has just been unbelievable. When we bought the stock, it was $8 a share.

The third company I mentioned, Scientific Games, makes online lottery machines and parimutuel gaming equipment. This is actually a recent buy for us (November). The company has won five of the last seven contracts it has bid on. And its cash-flow growth is starting to reaccelerate.

Q: What are the best sectors now for small stocks?

A: We're overweighted in consumer cyclical stocks. In fact, my three largest holdings that I mentioned would all fall into that category. As you know, the consumer throughout this whole recession and market downturn has continued to spend. And we continue to find stocks that are benefiting from that trend. Another one I could name in consumer cyclicals would be a retailer called Finish Line (FINL)a footwear and apparel retailer. It reported very strong sales numbers today and raised EPS guidance for the year.

Q: On the Small Cap Recovery Growth has it performed over the last three years?

A: It's an institutional product with a $5 million minimum. So it's designed primarily for institutions. The three-year number is an average annual return of 67.1%. That's vs. about 6.4% for the Russell 2000.

Q: Andy, are there are turnarounds in small-cap tech that attract you?

A: Sure. We just started buying recently a company called United Online (UNTD)which is the only national Internet service provider serving the low-price point. It's kind of like Southwest Airlines for the Internet. This company charges $9.99 a month, vs. more than $20 a month for AOL or other providers. I've heard good things about the company's service, and this firm has beaten its expecations on subscriber growth. Plus, the company is expected to be cash-flow positive in the June quarter -- two quarters ahead of schedule (for more on United Online, see BW, 3/18/02, "The Battle of His Life").

Q: Is there anything you like in biotech?

A: Up until very recently, the biotech sector has not done very well, and we have actually not made money in that sector, so I've had a low weighting in that sector. Right now, the only company I own is Transkaryotic Therapies (TKTX), whose main product -- which is close to a commercial launch -- is known as Replagal, which is for a rare disease called Fabry disease. It looks like this drug will be the drug of choice compared to another one from Genzyme (GENZ).... Both companies have their drugs already on the market in Europe, where the TKTX drug is gaining share -- also because it may have fewer side effects than the Genzyme drug.

Q: What about the micro-caps? Any plays there, or do you stay away from the tiny tots?

A: We do invest in some companies with market caps in the $100 million range. I'm trying to find one that's really small in our portfolio. Racing Champions (RACN) is very similar to the company Action Performance that I mentioned earlier -- the one that makes car collectibles for NASCAR. RACN we bought at $10 a share, and right now it's $19. Right now the market cap is $290 milion.

Q: Beyond your current favorites, what are some of the success stories you are proudest of?

A: In late '99, we invested in Digital Lightwave (DIGL). We bought it at $7 in the end of July '99 and wound up selling it all in the spring of 2000 at $130 a share. But right now, it's in a sector -- fiber-optic communications -- that's performing very poorly. And that whole telecom service provider area is very weak right now.

Q: Do you see any other potential small-cap winners in the Internet market? You mentioned United Online earlier.

A: We're always looking for Internet stocks We actually own Amazon (AMZN) in a couple of our other portfolios. E-commerce has been pretty strong this year. We've owned Ticketmaster (TMCS). Actually, we own that in one of our mid-cap funds.

Q: Any reaction to this question from the audience? I lucked out a couple of days ago -- bought DRRA

[Dura Automotive Systems] at $12.50, now $16-plus.

A: Actually, we just purchased that stock. They're a beneficiary of the strength in the auto market. They're an original-equipment manufacturer (OEM) for the auto makers. It's one where the trading volume isn't very high. The liquidity hasn't been there. But now that the company is gaining more interest, the stock is picking up also. But with the runup in DRRA, I'd be careful.

Q: Cyclicals have been hot lately. Do you like any economically sensitive names now?

A: We own several other restaurants and retailers. We recently bought Lone Star Steakhouse (STAR), which should benefit from higher consumer spending. Lone Star's same-store sales are stronger than those at Outback Steakhouse (OSI), and yet the stock trades at about half the cash-flow multiple of Outback's.

We also own Sports Authority (TSA). That's one where a lot of sporting-goods stores have actually closed down because of so much overbuilding in the industry -- and these guys are just one of the survivors. So now, Sports Authority's profitability and margins have risen dramatically because there isn't so much competition. The company is taking a lot of market share.

Q: You referred to your mid-cap fund -- what are your current favorites in the tiers above small-cap?

A: One of our highest weightings is Office Depot (ODP). We've made good money, but we still like it. Another auto-industry stock we like is ArvinMeritor (ARM). This company also is an OEM parts supplier to the auto industry.

Q: What is your favorite small-cap defense stock?

A: There have been so many mergers in defense. We do have a very small weighting in Applied Signal Technology (APSG), which is basically high-tech reconnaissance equipment or signal-processing equipment for radar and maybe also satellites.

Q: Any small-cap Internet security companies that you like?

A: We don't own anything in Web security. They all did quite well in the last quarter of last year, but they've sold off dramatically. We owned Rainbow Technologies (RNBO) until recently. We made a lot of money in (MCAF) but no longer own it. We sold that at the beginning of the year. We do own one in the mid-cap fund -- Network Associates (NET), which is the parent of

Q: What sector do you think will lead the small-cap recovery?

A: Over the next quarter, consumer cyclicals look the best. Further out, I'd expect a recovery in tech stocks, but not till at least the second half of '02.

Q: Finally, Andy, what stance do you recommend for investors now? Cautious bargain-hunting?

A: For small-cap strategies, I'd say it's a good time to be in the market in this sector, especially if you have a longer-term horizon. It's especially a good time for small-cap growth to kind of take a leadership position in the market. But, of course, you can't time the market. So you have to just find good stocks or good funds, and stick with 'em.

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