How Investors Can Tap The Small Biz Mother Lode

Small business accounts for over half of U.S. gross domestic product. But if you've tried to invest in the sector, you've likely been let down because most small businesses are private. The smallest public companies make a poor proxy because they've trailed the broad market for 20 years, with average annual returns of 15.7%, vs. 17.4% for the Standard & Poor's 500-stock index.

So other than starting your own company, how can you play the small-business sector? One way is via larger public companies whose customers are mostly small, private ones. In today's hot economy, where small businesses are thriving, it's no surprise that companies serving this market of 22 million customers are also doing well. The group includes payroll processors, staffing agencies, and other outsourcers, plus specialty lenders and office superstores.

Investing in such companies has an advantage over direct ownership of a small business: diversity. Small outfits tend to fail more often than big ones. But a huge retailer such as Staples serves thousands of small businesses. If one goes belly-up, it's no tragedy--at least not for Staples' shareholders.

Some of Wall Street's heaviest hitters have caught on to the small-business game. They're snapping up shares in national companies that cater to the smallest outfits--those with 20 or fewer employees, which make up 90% of the sector. "Brand matters in that world," says Brian D. Finn, a principal at Clayton, Dubilier & Rice, which controls the privately held Kinko's copying chain and has taken a $270 million stake in U.S. Office Products, the publicly traded parent of Mail Boxes Etc.

If you want to follow Clayton, Dubilier's example, you'll have to do some digging. There's no S&P industry group called "small business," nor is there much agreement on just how big a small business can be. The only shortcut we found was a database from Zacks Investment Research. Called Research Marvel (, $150 per year), it zeroes in on federally licensed small-business investment companies. Beyond that, we screened Morningstar and Value Line for finance, business service, specialty retail, and business-information stocks. Then we slogged through company documents to pick out those that specifically say they cater to small and midsize companies, tossing back any that concentrated on a single industry or region.

We turned up 23 companies, including seven with lengthy track records. As a group, those seven veterans posted an annualized return of 30% for the five years ended May 29--eight percentage points better than the S&P. Among the 16 newer stocks, only five trailed the market since going public.

SOME PAIN. Some of these companies fetch price-earnings ratios of 40 to 50. That should make you want to ask if their growth is sustainable, especially if a recession hits. Small private firms are likely to be hurt first and worst by any downturn, says David T. Kresge, chief economist at Dun & Bradstreet, which maintains the world's biggest database on such companies. Eventually, he says, suppliers would feel the pain, too. Even in good times, says Randall E. Haase, manager of the Alliance Quasar Fund, some outsourcers that do relatively simple tasks will last only until clients figure out how to do the jobs themselves.

That's why it's essential to seek out companies that add value to a client's business. Take Rochester (N.Y.)-based Paychex, whose market cap is $6 billion. Paychex thrives on small clients (the average size is 14 employees), and it does an essential task (payroll and benefits processing, notoriously complex and time-consuming). At 38, the stock sells for 48 times estimated fiscal '99 earnings. But Paychex has a long record of growth, with earnings up every year since 1990.

What's the next Paychex? Haase has his eye on Century Business Services, which is gobbling up dozens of smaller rivals to create one-stop shopping for accounting, payroll processing, benefits, human resources, information technology, and insurance. The Cleveland-based company is already ranked as the nation's 11th-largest auditor, operating in nearly every state, with 72,000 customers and estimated revenue of $300 million this year. Its goal: $1 billion by 2001.

Making all those takeovers work is a high-risk game. But it's a tried-and-true formula for CEO Michael G. DeGroote, who became a small-business legend by building a tiny Canadian bus company into the giant Laidlaw Transportation empire through more than 600 acquisitions. "This is not dissimilar," says DeGroote. "I know all the dos and don'ts." A less heralded stint at Republic Industries and a 1993 run-in with securities regulators--settled without DeGroote admitting any wrongdoing--apparently haven't dulled his touch. Century's stock, which was under 2 in 1996, is now at 17. Ty Govatos at Donaldson, Lufkin & Jenrette expects it to reach 26 within 12 months.

Other big beneficiaries of small-business growth include office superstores, led by Office Depot, OfficeMax, and Staples. But the superstores can't do it all. New England Business Service, for example, has carved out a niche by selling customized business forms. Chairman Robert J. Murray, a former top Gillette executive, says NEBS has a killer mailing list with 1.5 million clients. He's adding customers through a new Web site, kiosks at branches of Fleet Bank and Wal-Mart Stores, and his own string of acquisitions.

Buyouts hurt reported profits because of goodwill write-offs. But on a cash basis, Wall Street expects NEBS earnings to rise to $2.50 in fiscal '99, up from $2 this year and $1 in '96. That's one reason NEBS is a pick of Michael Maloney, partner at top-performing Skyline Special Equities Fund. He figures the shares, now 33, should hit 42 next year.

Perhaps the most intriguing plays are specialty lenders, such as Allied Capital, based in Washington, and Sirrom Capital, based in Nashville. They borrow cheaply and lend at double-digit rates. On top of that, they get equity "kickers" in the form of warrants, options, or shares. Allied, for instance, has a piece of Gibson Guitar, while Sirrom took a stake in Wolfgang Puck Food, the celebrity chef's cafe and frozen food outfit. Lenders carry the kickers at original cost until the borrower goes public or gets bought out. The result is a store of hidden value that doesn't show up on the balance sheet. How much? Who knows, says Allied Senior Vice-President Suzanne V. Sparrow: "It's not only hidden from you, it's hidden from us."

Allied says it deals in more established companies, which helps it maintain a 5.75% annual dividend. Sirrom goes for a broader portfolio of smaller high-growth service companies that banks might not touch. Sirrom acknowledges that more of its deals might go belly-up, but CFO Carl W. Stratton figures geographic and economic diversity--along with the equity kickers--will more than make up for possible losses. So far, the strategy has worked; earnings have risen steadily since the stock's '95 debut and annualized returns have topped 70%. "They underpromise and overdeliver," says Arden C. Armstrong, manager of mas Midcap Growth Fund.

Sirrom is not for the squeamish. It's a favorite with momentum investors and short-sellers, and even some admirers ask how well the loan portfolio will hold up in a weaker economy. That's worth pondering for all these stocks. But with no recession in sight, the big names in small business have more room to grow.

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