Small Caps for Growth -- and Value

Century Small Cap Select Fund's Kevin Callahan hunts for both qualities, and believes he has found them in FLIR Systems and Serena Software

For growth stocks these days, look to three industries -- health care, finance, and insurance. That's the recommendation of Kevin Callahan, director of research for Century Capital Management and co-manager of the Century Small Cap Select Fund. Callahan describes himself as "a growth manager with a value overlay," seeking companies with strong fundamentals selling at an attractive valuation.

In health care, Callahan prefers investing in companies that provide the "picks and shovels" to the bigger pharmaceutical companies. As an example, he cites Charles River Lab (CRL ), which provides mice and rats to the pharma giants for use in their research.

Among the small caps Callahan likes are FLIR Systems (FLIR ), which provides imaging systems primarily for the military; insurance brokerage Hub International (HBG ); specialty retailer Cato (CTR ); and life insurer Universal American Financial (UNCO ). He also mentions a few tech stocks, including Ascential Software (ASCL ) and Serena Software (SRNA ).

Callahan made these and many other points in an investing chat presented Aug. 28 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available on AOL at keyword: BW Talk.

Q: Kevin, what do you make of the market's marking time? Will September bring a durable rally? Is the bull back?

A:

Well, personally I hope the bull is back. It's much more favorable to be in this business when the market is going up. I do have some concerns, though, and they focus more on the fact that the tech sector has gone very far in a short period of time. When people come back from vacation in September, there may be concerns about valuations and earnings estimates...but I do think the economy is starting to improve overall...and in the stock market as well.

Q: What about the NASDAQ's recent spurt?.

A:

I think the NASDAQ, reflecting a lot of these soaring tech companies, has been astronomical. It has been a fantastic year, but again my comments earlier about earnings -- where they're going to come from -- relate to the NASDAQ.

I believe some stocks that have performed extremely well over the last four or five months have very little in the way of earnings. Sooner or later, companies need to have earnings, and if these don't materialize, valuations are likely to crash. I do have some concerns that the NASDAQ will be able to hold where it is, improvements in the economy and increases in capital spending notwithstanding.

Q: What are the growth industries in today's market, in your opinion?

A:

In the short term, I'd favor those that have the best pricing power today. That includes the health-care area, as well as finance and insurance. For example, in health care, the premiums that we're all paying are increasing at a rate of around 15% per year. What that means for a company in the health-care industry, without growing in volume at all, that's 15% growth. We're seeing similar trends in insurance, especially property and casualty. There are also 15% annual rate increases there. Those are just two industries that have great pricing power, and both will grow very well.

Q: Kevin, tell us about how you pick stocks for the Century Small Cap Select Fund (CSMVX ). Are you value or growth, or somewhere in between?

A:

At Century, in terms of the Small Cap Select Fund, we're a small-cap growth manager. To explain that more fully, we're probably more a growth manager with a value overlay. By that, I mean we look for companies with strong fundamentals in terms of high return on equity, high percentage of recurring revenue, high growth rate, both top-line and bottom-line.

We look for all those aspects, but at the same time we like to buy those companies at attractive valuations.... What we try to emphasize is that we're looking for stocks that would perform well over time. We're not trying to make significant returns over the next quarter or two -- we're looking over a two- to five-year time horizon. As a result of this approach, we have enjoyed strong risk-adjusted performance, in that our returns have been very attractive while the risk profile of our fund has been below average.

Q: Back on health care, what do you think about health-care companies like Aetna (AET ) and Cigna (CI )?

A:

Aetna and Cigna are national players in the health arena that have an extensive history. Unfortunately, in recent years both companies have experienced significant challenges. Management is trying to work through these challenges and reinvigorate the companies, but they still have a fair amount of time to go to overcome these issues.

In terms of health care, one of the things that we think about when investing is that we try to invest in companies that provide the "picks and shovels" to the industry, rather than betting on some of the players themselves. In health care, we own some pharmas that dominate the industry. [However,] I don't have a PhD in medicine, so I would be no better than anybody else to determine if a pipelined drug would be a success or failure.

So what we bet on is the companies that help design the drug. We own Charles River Lab (CRL ), which provides mice and rats to the pharmaceutical industry for their research efforts. They're dominant in the industry, and they've benefited from pharmas expanding their research efforts. We give up some upside potential by investing in these companies vs. pharmas that may develop blockbuster drugs, but we also avoid the downside.

Q: What's your view of Compass Bancshares (CBSS ) and other regional-bank stocks?

A:

I think the regional-bank stocks have benefited from the decline in interest rates over the past several years. This has helped them in terms of their funding costs declining over time, while at the same time benefiting from a boom in mortgage refinancing. The challenge that these banks face going forward relates to the same benefit they've received over the years -- which is interest rates. These have increased dramatically over the last four to five weeks.... My own expectation is that rates will continue to rise as the economy steadily improves, so I think as you look to invest in the regional-banking industry, you need to keep those issues in mind and understand that companies that have benefited significantly from these two trends may be susceptible to weakness unless they change their strategic approach.

Companies that we currently favor: two regional banks, SouthTrust Corp. (SOTR ) and Banknorth (BNK ). They have good management teams and pay a good dividend of about 3%.

Q: Do you like any specialty retailers?

A:

I do like some specialty retailers.... Two stocks that I have owned include Tuesday Morning (TUES ) and Cost Plus (CPWM ). We initiated positions in both these stocks in the first quarter. While we continue to like them both, today, from a fundamental perspective, the stocks have been very strong performers, and they're currently trading at the high end of their valuation ranges.

I should note that we sold our position in Tuesday Morning because of the runup and have trimmed our position in Cost Plus. The reason for this was simply valuations. In terms of the company's strategies, models, and opportunities, we still find them both attractive.

Q: Will small caps continue to lead?

A:

Well, I hope so. But it wouldn't surprise me if we had a period of consolidation in the short term. Small caps have significantly outperformed the whole market this year, and the outperformance is not totally unexpected, in that we expect small caps to outperform the whole market as the economy strengthens.

At some point, there will be a shift over to the mid- and larger-cap stocks. In terms of the timing, it's difficult to forecast, but I would expect it to happen sometime over the next 12 months.

Having said that, we here continue to focus on companies whose prospects will remain attractive for the next two to five years. So while there may be some consolidation in small caps overall, we hope to continue to perform favorably, given our bottom-up and in-depth research approach. Our performance over the past one-, two-, and three-year periods shows that our style of investing can produce strong results despite how the small-cap indexes perform.

Q: Can you name your five favorite small caps?

A:

Well, let's start off with FLIR Systems (FLIR ), which is a leading manufacturer of imaging systems, primarily for aircraft, used by the military and other clients. This company makes products at the high end of the market while at the same time being a low-cost provider. The company is generating a return on equity in excess of 25%, and I expect the company to benefit from future security initiatives, both in the U.S.and abroad.

A second company that I like is Hub International (HBG ). This is an insurance-brokerage company with operations throughout North America. This company has benefited recently from improved pricing in the insurance industry, while at the same time improving the efficiency and productivity of its own operation. I expect the company to continue to grow earnings in excess of 15% over the next couple of years, while also improving its return on equity.

A third company that I like in the retail space is Cato Corp. (CTR ), which is a specialty retailer offering lower-priced apparel products. This company has generated an attractive return on equity over the past several years of approximately 20%, and my expectation is that they should be able to maintain that level going forward. This company also pays a dividend of 2.8%, which should help support the stock if we experience any market turmoil. Finally, I should note that I view them more as a 2004 story, because they'll benefit from an improving economy.

A fourth stock is Universal American Financial (UNCO ), which is a life-insurance company and administrative-services company. This company's market focus is on the senior marketplace, and it should benefit from an aging population. In addition to the life-insurance product, their administrative services business provides outsourcing of insurance and noninsurance products, primarily for the senior market. And we'll leave it at four to take some other questions.

Q: Despite some high valuations, are you finding any tech stocks worth buying now?

A:

Yes. We have been purchasing a few different software companies. Currently, we own Ascential Software (ASCL ), which provides enterprise integrative solutions. We also own Serena Software (SRNA ), which provides infrastructure software solutions. A third name would be Online Resources (ORCC ), which might be classified as a micro cap. It's a leading outsourcer of e-financial services to regional and community financial institutions.

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