Sparrow Fund Manager Sees Small Caps Leading Toward a Recovery

Gerald Sparrow, founder and chief investment officer at Sparrow Capital Management Inc., (SGFFX) said small-cap stocks will lead the market toward a recovery.

``Small caps tend to go down first and then they come up first,'' Sparrow said in an interview Sept. 26 in New York. The reason for that, he said, is their higher risk.

Sparrow, 49, started his St. Louis-based investment firm in 1998. Before that, he worked for Strong Capital Management Inc. A veteran of the U.S. Marine Corps, Sparrow has a master's in business administration from Washington University in St. Louis.

The Sparrow Growth Fund outperformed the Standard & Poor's 500 Index in 2007 with a 9.7 percent return to the S&P's 5.5 percent. The fund had assets of $15.3 million as of June 30 and holdings in 43 companies. Its biggest stakes were in Occidental Petroleum Corp. and Chesapeake Energy Corp.

The Value Line Index, which measures the yield on stocks, is used by Sparrow to gauge the market. The last time the yield was as high as it is was in 2002 and 2003, when the market hit bottom, he said.

Some of the stocks he likes include clothing retailer Abercrombie & Fitch Inc., (ANF) Central European Distribution Corp. (CEDC), a vodka distributor, and toolmaker Makita Corp. (6586)

Jeffrey: What are the criteria you use to pick stocks?

Sparrow: We have an investment philosophy where we believe companies grow their shareholder value over time as they grow their sales, earnings, cash flow and book value. And our investment process tries to identify companies that have a track record of doing that for the shareholders.

The process that we use is a three-step process.

We screen different databases like Value Line, Zack's, Reuters and Bloomberg and try to identify industries and companies that are showing some relative strength in their share prices.

Then we'll go in and we'll score stocks using a proprietary matrix, for EPS growth, return on equity, strong balance sheet, estimate revisions, and shareholder-friendly management.

And once we score those stocks and identify those we think have good potential for creating shareholder value we'll actually go in and listen to some of the quarterly Webcasts where companies report to Wall Street what their results are.

We'll also read their original source material and run some different metrics on the company, to really look at their growth rates relative to their valuations.

Then we use a tactical approach, more of a short-term strategy, to try to buy the shares on the cheap. So if the company has a seasonal trading pattern to it, whether it's a retailer or energy company, we'll try and buy those stocks during a period when we know there's a low level of information out there and stocks will be trading lower. So we'll accumulate those shares based on tactical measures short-term.

Jeffrey: Do you think small caps will lead the market during a recovery and why?

Sparrow: We think small caps will lead the recovery in the economy because there's more risk in small caps. So small caps tend to go down first and then they come up first.

Jeffrey: Which sectors will do well in a recovery?

Sparrow: The names we think will do well coming into a recovery are going to be consumer cyclical names and financial service companies.

On the consumer cyclical side you probably want to focus your energy on retail names such as clothing manufacturers -- more the high-end, like Abercrombie & Fitch, the high-end retailers because as consumer budgets begin to improve they will have more money to spend on higher-end products.

Also, on the financial-service side, we're spending a lot of time on banks right now because a lot of banks are trading below book value and that's typically a time when you can buy banks on the cheap. And when the recovery comes around and home prices stabilize, these banks will trade at one-and-a-half to two times book value.

Jeffrey: Which particular financial-services stocks do you like?

Sparrow: Right now we own Eaton Vance, the money-management company. A lot of their products are diversified. So they have equity products and fixed-income products, and when investors move back into equity markets they'll be able to get more fees per unit of sale.

Jeffrey: What companies in other sectors do you like?

Sparrow: We like some international names, like Central European Distribution, which is the largest vodka producer in Poland. We also like a tool manufacturer -- the business is cyclical and the reason is a lot of home-building companies rely on tool manufacturers to put the nails in and drive the screws in the wall. So we like Makita, the symbol is MKTAY, and the reason is because they're selling at a reasonable price relative to their book value and we think they have a very strong brand name among professional tool consumers. And they'll be one of the first beneficiaries of the turnaround in the housing market.

Jeffrey: What sectors don't you like?

Sparrow: I think the consumer-staple area is somewhat -- not overvalued but -- fairly valued. So a company like Church (CHD) & Dwight, which is the maker of Arm & Hammer baking soda and products such as those -- they have a great track record. We own the stock. We're not adding to the position because they are in the consumer-staple area and everyone's been crowding into that space because it's a safe space. They have a consistent track record growing their earnings through recessionary periods. But those are the times that you want to hold the stock and wait for better opportunities, when stocks sell off, when we start to come out of a recession.

Jeffrey: How is the credit crisis affecting some of the companies you own?

Sparrow: We own MDC Holdings (MDC), which is a home builder, and they've had the strongest balance sheet of any of the home builders that we've looked at. And they're obviously affected by the credit crunch. We have not made any money on the stock. We've been in it over a year and we do know that they're conservatively managed. The symbol is MDC. They have a strong balance sheet, and they're a good valuation. When home sales improve they'll be one of the first beneficiaries. So we're looking for survivors in that space and we think they're going to be a survivor and be able to come out of it strongly.

Jeffrey: Any other companies you're interested in?

Sparrow: The space that we're looking at where we're spending a lot of time is bank stocks and financial service companies. We don't own UCBH bank. We've owned it in the past. They've got a great franchise in the U.S., Asian market. They have offices in China -- they're out of San Francisco. They're a well-managed business. It's a name we don't own. We're looking into it for possible purchase.

Jeffrey: Any overall thoughts about your investment philosophy?

Sparrow: I think that overall the markets are, and investors are, scared right now and there's a lot of pessimism in the market. If you look at the yield on the Value Line Index -- they track the yield and the yield is high right now. In other words, there's good value in the stock market right now. If you compare the yield of the Value Line average to its past periods where it signaled the bottom, the last time the yield was as high as it is right now was back in 2002, 2003, when the market hit bottom. So the appreciation potential in the yields is very high right now.

And what we do, in our investment philosophy, is we buy growth at reasonable prices. So we've been accumulating these stocks through this down period and we know these companies are going to be survivors. They make products and goods and services that have always been around -- and they're going to be around -- and now's the time in our opinion to add to those holdings.

To contact the reporter on this story: Don Jeffrey in New York at djeffrey1@bloomberg.net.

To contact the editor responsible for this story: Colleen McElroy at cmcelroy@bloomberg.net.

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