Small-cap stocks are off along with the rest of the market, but the small-growth category should do well again in an upturn, according to Paul Phillips, co-manager of the Enterprise Small Company Growth Fund. In any case, Phillips thinks any time is a good time for long-term investors to be in the market.
In the small-cap arena, he sees particular promise in technology and other cyclical-growth stocks, as well as medical-device companies. In tech, he cites software as a promising play because of pent-up demand and its potential for improving productivity.
The Enterprise Small Company Growth Fund, according to Phillips, invests in stocks with market capitalization under $1.5 billion. Its top holdings include information-technology consultant CACI International; FLIR Systems, which makes imaging and heat-detection systems; and ZOLL Medical, which is on the drive to put automatic defibrillators in public places.
These were a few of the comments Phillips made in a chat presented Sept. 26 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts. A complete transcript is available on AOL at keyword: BW Talk.
Q: Paul, the Dow almost made it back to 8,000 today. Do you think the bottom is behind us (so to speak)?
A:We think that the market is in a bottoming phase, and we think that many of the preconditions for a rise are in place. We doubt that there'll be a major move upward until there's some resolution to the Iraq issue.
Q: Can you tell us what some of those preconditions for a market rise are?
A:Some of them are [a reversal of] low expectations -- which has certainly been the case since spring, 2000, with the Nasdaq off over 75%, the S&P off 42%, and the Russell 2000 off a similar chart decline. That's one. Another is an improvement in the economy, and we believe that the recession of 2001 is over (the two causes of that recession were inventory liquidations and a sharp decline in capital spending).
We think, certainly in the retail areas, that inventories are increasing. The inventory-to-sales ratios are now in a status where you're going to have sales elevated soon to meet demand. With regard to capital spending...and adding to work forces...we would expect at least mild progress to be made over several quarters.
Q: What are you looking to buy right now? Also, is this the time to get back into the market?
A:I think this is certainly time to get into the market. I think for long-term investors, it's always time to be in the market.... As for the other question, we're looking at some areas that we're trying to identify for the Enterprise fund: growth at a reasonable price, companies with price-earnings ratios not in excess of a long-term growth rate, so the price-earnings/growth ratio is 1 or less. We also, when we're buying a new stock, like to have an expectation that -- between earnings increases and a combination of an earnings increase and p-e elevation -- you would be able to achieve a 25% return in one year. We continue to do this, even in light of the last few years, and think it's a good practice.
Looking at the market today, and areas we think warrant examination -- tech and other cyclical-growth stocks that have been under pressure this year through Sept. 18 -- one area we really want to look at is software companies. In talking with managements, we recognize that, in many major companies, there are requests for applications software just stacked on desks. So we think because of that, and also because of the tremendous productivity gains that come from software, that's a place where we really want to see what's available.
A second place we continue to look at is the medical-device field, where, in many cases, the companies have not been under the pressure that the techs have. We expect strong long-term secular growth in that sector. One company we have confidence in is ICU Medical (ICUI ), a California-based company that makes IV-therapy systems. They've used software extremely effectively to have their costs significantly lower than their competitors'. They work closely from a marketing standpoint with Abbott Labs (ABT ).
Q: Paul, how has your fund performed this year? Can you give us a rundown of your record?
A:Sure. The fund this year was off as of [Sept. 25] 31%, which is obviously significantly below the indexes but basically the same level as the median performance of the Lipper. For the four years that our firm has managed the fund, the compound annual return was 8.14%, which compares with 5.09% for the Russell 2000 and 0.23% for the S&P 500.
Q: What's your fund's definition of "small"?
A:Companies with market capitalizations of $1.5 billion or less. The fund is required to have 80% of its assets in that category.... There are about 4,000 small-cap names -- and 47 names in our fund. In our universe, which is a fluid one, there are between 150 and 175 names. So there is, unfortunately, a vast number of issues we don't look at. We don't buy anything with a market cap under $100 million. We stick to companies that have strong financial characteristics, particularly in tech areas.
Q: So what are some of the top holdings in your fund?
A:One of the top holdings is CACI International (CAI ). This company is an information-technology consultant. Over 75% of the business is [with] the government. They have over 2,000 employees, half of whom have top-secret clearance, and you need that to work on Defense Dept. communications systems.... They work on software, developing systems for different branches of service. We'd expect them to have continuous earnings.
FLIR Systems (FLIR ) is another one. They have two main businesses: imaging systems used in defense and a...heat-detection system that allows firefighters to determine if there's human life in a building. It has been used very effectively. Varian Medical Systems (VAR ) is another, which has now moved beyond the $1.5 billion market cap but has doubled since we bought it. Its specialty is radiation equipment that can be used to isolate and kill tumors without damaging surrounding tissue.
ZOLL Medical (ZOLL ) is another. ZOLL has produced defibrillators. The really big push is now for...automated devices that could be used in airplanes, stadiums, and maybe even offices. There's a strong movement to have these available everywhere, and automated ones that are easy to use, which ZOLL has developed. We expect them to do very well -- great cash position, no long-term debt, and good independent R&D.
Q: Given that your fund tends to focus on tech, are you worried that earnings in the sector don't seem to be recovering as quickly as previously thought? Or are your small companies in the fund faring better than larger companies on the earnings front?
A:The majority of the companies are certainly having difficulty in establishing earnings increases at this time, with a few exceptions.... We think what this sector needs is an increase in capital spending, which will happen as we go through the next few quarters.
The reason we stay with it is really the software companies. Once the market gets positive, these stocks can move extremely quickly, and with less liquidity we would expect some consolidation to go on within this sector. There are individual pockets. Drexler (DRXR ), for example, is a company that focuses on developing identification cards for the government. They do virtually all of the green cards for the INS, etc. Italy is moving toward a national card, as is India. There are cards with thumbprints, retinal scans, etc. Drexler has developed a very durable card of this type.... Technology is the basis of productivity increases, so it's going to be important in any economy.
Q: How do you manage the downside volatility in a small-company fund where stocks are more illiquid and volatile?
A:We manage the downside by trying to concentrate on the companies that we have the greatest confidence in to achieve earnings growth -- for example, FLIR and CACI. Having less in companies such as semiconductor equipment, which have great enabling technologies but rely too much on massive capital spending, helps us focus on the ones in which we have the greatest confidence. We diversify and try to stick with companies that have financial strength.... Tech is about 26% of our assets. The largest single sector right now is health care, which is 27.5% -- 17% is commercial services.
Q: Any small emerging pharmas or biotechs you like?
A:We have one that's related to that field, called Varian (VARI ). They develop instruments for testing new drugs, and that's one of their businesses. They also have some industrial business. This company is developing instruments that are used in tests for very, very early drug discovery, which is a very complex process and requires an extraordinary amount of time and money. Their products are used to increase the speed of this very early stage. That stock has done relatively well, and we expect them to earn around $1.46 [per share] this year. They earned $1.29 last year. It has relatively little debt as well.
Q: How long do you think small-cap stocks can continue to outperform large caps?
A:Small caps, as judged by indexes such as the Russell 2000, have outperformed large caps since the first part of 2000. Since June, the Russell has gone down more than the S&P, but I think the significant thing from where we stand is that the category of small caps generally has done better than large caps. Small-cap value companies, which we don't often own, often do much better than growth stocks, which have been pushed down hard. Going forward, we believe that small caps will do extremely well in an upmarket, and we do feel it would be the growth-oriented stocks that do well.
Q: Paul, what do you think distinguishes your fund from other small-company funds?
A:I think the fund is concentrated -- 45 to 50 names is relatively concentrated for a fund of this size. We [keep] the focus on p-e ratios, their relationship to earnings growth rates, and low turnover. The turnover in the fund this fiscal year is 28%, and with the exception of the year when we took over the fund, the turnover rate has been between 20% and 40%. Good ideas take years to develop, and if an idea is any good, you never know when a burst of interest is going to come along. So this long-term focus is definitely an interesting characteristic of the fund.