Sharpshooting for Micro-Caps

Robert Sullivan of the Satuit Capital Micro Cap Fund explains his stock-picking strategy in a market he sees poised for a break

"Maybe it's time for the market to take somewhat of a pause." That's part of the analysis from Robert J. Sullivan, portfolio manager of the Satuit Capital Micro Cap Fund (SATMX ), based on the 17.37% return of the Standard & Poor's 500-stock index over 2003 and 2004. Now, perhaps, the market will take five and "try to build a base for the next move upward," Sullivan adds.

In this environment, Sullivan considers the market as one for stock-pickers, offering a solid return -- albeit not as much as in the recent past. In managing his own fund, he hunts companies with under $500 million in market capitalization, a "reasonable" price-earnings ratio, and an above-average growth rate in earnings per share -- a philosophy that has produced 85 holdings for the fund.

Commenting on specific stocks, Sullivan points to several he likes in the energy sector, among them Dawson Geophysical (DWSN ), Dril-Quip (DRQ ), and Remington Oil & Gas (REM ). For the sector generally, however, he voices some concern over valuations.

These were some of the points Sullivan made in an investing chat presented Mar. 17 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and June Kim of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at keyword: BW Talk.

Q: Bob, first let's get your macro view of what's going on in the market.

A:

Well, let's take a step back for a little historical perspective. If you look at 2003 and 2004, the market as measured by the S&P 500 over that two-year period was up 17.37%. When you take a look at that kind of two-year return throughout history, you can't help but think maybe it's time for the market to take somewhat of a pause and try to build a base for the next move upward.

My sense is if we look at what's in front of us for this year -- namely, the higher price of oil, rising interest rates, and an economy that's in second gear, but certainly hasn't moved into third or fourth -- my sense is the equity markets will provide investors with a solid return, but certainly not the types of returns we've seen for the last two years.

Because of that, I believe we really need to focus on two things. First, making sure our portfolio is invested properly across all strategies. And second, from my perspective as a portfolio manager, I'm really going to need to understand what will be the driver of the fundamental story of the companies that I own -- i.e., it's going to be a real stock-picker's market in 2005.

Q: Can you tell us about your investment style? How will you pick your stocks in 2005?

A:

The investment philosophy at Satuit Capital Management is stocks that have a reasonable p-e multiple and an above-average growth rate in earnings per share will outperform the broad market over the long haul. It's your traditional growth-at-a-reasonable-price philosophy, aka GARP.

The process I go through is a small quantitative screen to create the universe, which is limited to $500 million of market cap or less. We put that through other filtering processes to come up with companies we feel have the best characteristics for long-term growth. At that point, the final process kicks in, a rather boring but comprehensive bottom-up analysis. We look for drivers of sustainable revenue growth, margin expansion, balance-sheet strength, and cash flow. If I can get my arms around those four themes, I'll consider that company for investment in the portfolio.

Q: How about the energy sector? Any micro-cap energy stocks you recommend?

A:

Energy certainly is thematic and has been over the past 18 months. We do have an exposure in the energy sector. Our portfolio weight is close to 10% of assets, which is somewhat overweighted vs. the Russell 2000 index. We own a couple of interesting names -- one being Dawson Geophysical (DWSN ). They are the largest on-shore seismic data supplier to oil and gas companies.

The second name we like and own is a company called Dril-Quip (DRQ ). They design and manufacture wellhead and drilling products. Those are two names on the services and equipment side. On the E&P [exploration and production] side, we like Remington Oil & Gas (REM ), which is an E&P shallow Gulf of Mexico, Texas, Louisiana, Mississippi company.

We've been somewhat underweighted in the sector in terms of being able to provide additional performance in the portfolio. The valuation levels of some of these names have just gotten above where we would feel comfortable taking new positions.

Q: What are your picks if it's a stock-picker's market in 2005, besides the names you've given us?

A:

Well, my favorite pick of all is the fund itself. But more to your point, there are currently 85 holdings in the fund. Each one of them has the characteristics that we feel will generate long-term returns for our shareholders. One of the advantages of investing in this group of companies is there are so many of them to look at.

It takes time to find them, but they are there, and you can find the companies that have a 13 multiple and 30% earnings-per-share projected growth rate overlooked by Wall Street and investors. Those are the companies we like and will invest in.

Q: Any thoughts on American Retirement Corp. (ACR )?

A:

Absolutely terrific performance from the lows of 2003. The stock has gone from $2 and change, and closed this evening at $14.30. It's in a terrific niche where the company owns, operates, and manages various senior-living communities throughout the U.S., providing independent living, assisted living, and skilled nursing services.

The stock currently is very attractive, at 21 times '06 numbers, and a 58% growth rate ('06 over '05). Most of the earnings estimates I've seen have been moving up. My only concern would be issues regarding Medicare, Medicaid, and reimbursements. That can be a real chink in the armor for these types of companies.

Q: What's your opinion of Commercial Metals (CMC )?

A:

Another terrific performer. Not a holding in the fund, although we've looked at it in the past. I would be very careful of their cost structure and their ability to pass on their cost of goods back to their customers via pricing. If you own this company, understand the difference between FIFO and LIFO inventory and make sure you know what inventory accounting measure they're on, because if there's a dramatic change in their cost structure, it can kill the earnings.

Q: What do you think of the tech sector? Do you like any tech stocks?

A:

The tech sector right now is fraught with investors, Wall Street analysts, and portfolio managers doing their best trying to pick a bottom in the semiconductor cycle. I'm not immune to that thought process either. The tech sector, as defined by semiconductor and semiconductor capital equipment, has been a tough sector to invest in. We need to continue seeing signs of end-market demand, and we have been seeing that in terms of consumer electronics, PCs, notebook PCs, telecommunications demand, etc.

Where I'm having a hard time connecting the dots, if you will, is the issue of semiconductor capacity. At the end of the day, semiconductor manufacturing is a commodity industry, and I've never known a commodity industry to be able to have any kind of pricing power if you have lots of capacity. We don't see robust demand for semiconductors, although it is there, but we certainly have a lot of capacity.

In the fund, we only have two investments in semiconductor land. One is Sirenza Microdevices (SMDI ). Sirenza designs and manufactures semiconductors for telecommunications applications. And the other holding in semi land is Netlogic Microsystems (NETL ). They make what are known as knowledge-based processors for high-end Internet and corporate systems. We don't have any exposure in semiconductor capital equipment.

Q: Do you have any favorite biotech issues?

A:

It's better to own a fund or group of biotech stocks than to own an individual stock. An example would be what happened to Genentech (DNA ) this week. It's very difficult to handicap results of trials. Having said that, I do manage a biotech fund called the Genomics Fund (GENEX ). I've tried to create this fund to be diversified in the sense that we have biotechnology, we have capital-goods companies, and we have consumables companies. This takes away some of the individual stock risk that allows us to invest in a broad universe of companies.

Q: If one of your micro-caps prospers and climbs into a higher category, do you sell? When and why do you sell, generally?

A:

A company will be sold outright from the portfolio if it reaches $1.2 billion in market cap. That's one of those good problems to have. Along the way, for example, if we bought the company at $380 million of market cap, and it got to around $750 million, at that point I'd most likely trim it back to a 1% holding. In effect, its market cap has doubled from where I bought it. And since we start each initial position at 1% of portfolio assets, and it has doubled, that's a good thing.

We still want to keep some of the company in the portfolio, unless, of course, the valuation has become unattractive. We will also sell a company outright if there is a change in the fundamentals.

Edited by Jack Dierdorff

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