"Screaming Buys" Among The Small Fry

Little guys in industry, finance, and energy look hot

Over the past year, investors' experiences with large-cap stocks have ranged from disappointment, as with IBM (IBM) or Wal-Mart Stores (WMT), to outright disaster, as with Lucent Technologies (LU) or Yahoo! (YHOO) But in one little dark corner of the market, some savvy investors are delighted with returns from small-company stocks that most have never heard of--auto-parts makers Simpson Industries (SMPS) and Tesma International (TSMA); or Agrium (AGU), which produces fertilizer.

Yes, small caps are back--but not the tech whizzes that so dazzled Wall Street in 1999. Those are "small-cap growth" companies, so named because of their perceived high-growth prospects. Since the Nasdaq peaked in March, many small-cap growth stocks have been in a death spiral. The Russell 2000 Growth Index, a barometer of their stock price performance, is down 19.6% so far this year. Small-cap value stocks, which are mainly small industrial, financial, and energy companies--yes, Old Economy stocks--are in the pink. The Russell 2000 Value Index is up 16.7%, and the sector's prognosis for the new year is continued good health.

What's going on? Historically, value stocks have been economically sensitive, falling as economic growth slows and rallying as the economy climbs out of recession. Yet growth is slowing, and these small-cap value stocks, with market capitalizations of $2 billion and under, are on a tear. There is a reason for this odd behavior, says Satya Pradhuman, a quantitative strategist at Merrill Lynch & Co., who focuses on small-cap stocks: "You have a lot of stocks that are priced as if we're in a recession," he says. In effect, he says, small value stocks never recovered from the global market crisis in late 1998.

The result is rock-bottom valuations. The price-to-book value ratio of the Russell 2000 Value index is an exceptionally low 1.5, vs. 5.4 for large-company stocks. That valuation gap has existed for more than two years, but it wasn't until recently--when the large-cap glamour stocks stumbled--that any attention was paid to the mundane little companies.

Now, investors are taking notice--and so are corporate buyers. Not only are the stocks cheap, but they're small enough to be bought by big companies using pocket change. "Over the last 18 months, 15% of our holdings got bought out by larger companies," says Robert H. Perkins, portfolio manager of the Berger Small Cap Value Fund. "If the investing public doesn't want to recognize the value, Corporate America will." And those acquirers have been willing to pay substantial premiums. This June, Ingersoll-Rand (IR) acquired one of Perkins' holdings, refrigerator maker Hussmann International, for a 116.7% premium over its pre-deal price.

SELF-SUFFICIENT SECTOR. Most value investors don't go looking for takeover candidates. It's a natural benefit of owning cheap stocks. Perkins buys companies well off their stock-market highs that trade for low multiples of free cash flow. Free cash flow takes net earnings and adds back depreciation and amortization (noncash charges), but subtracts capital expenditures and dividends (which use cash). The idea is to see how much "leftover" cash a company has after one year of business as usual.

Such companies are self-sufficient enough that they don't need outside financing to grow. With the extra cash, they often buy back their own stock, which increases earnings per share. Two Perkins favorites are Manitowoc Co. (MTW) and Tecumseh Products (TECUA). Manitowoc is the largest crane manufacturer in the world and a leading player in the ice-machine business. Tecumseh makes lawnmower engines. Both companies are buying back shares. Both are generating large amounts of free cash flow and sell at bargain-basement prices. Manitowoc trades at 11 times free cash flow and Tecumseh at 14 times.

Portfolio manager John Burbank of State Street Research Aurora Fund tries to buy companies selling at a discount to what he calls their private market value--what a knowledgeable investor in the industry would pay for the whole company. With that analysis, he thinks there are some "screaming buys" in old industrials, particularly in the auto-parts industry. His favorites, Lear (LEA) and BorgWarner Automotive, are both selling below book value and less than seven times earnings. That, he says, makes them cheap even though the auto industry is slowing. Lear currently trades at 4.5 times cash flow, while the average in the auto-parts industry is 6.1.

While value investors gravitate to the tried and true, some will venture into technology and telecom if the price is right. Jerome J. Heppelmann of PBHG Small Cap Value Fund says many fallen tech companies are now on his radar screen. His current favorite is CTS Corp. (CTS), an electronics components supplier that's 49.6% off its high and trades at just 11.9 times next year's earnings. The Berger Fund's Perkins likes telecom equipment maker AVT (AVTC), at 4.94 and with a p-e of 11. What interests him is that AVT's closest competitor, Active Voice Corp. (ACVC), was recently acquired by Cisco Systems Inc. (CSCO) He figures AVT, now 86.3% off its 52-week high, could be next.

RECESSION THREAT. A problem with small stocks is liquidity--which means the ability to sell a stock quickly without taking a hit on price. That's got some institutional investors shifting upscale into mid-caps, with market capitalizations from $2 billion to $10 billion. Indeed, mid-cap value stocks have done nearly as well as small-cap value. Strategist Christopher Wolfe of J.P. Morgan & Co. suggests PartnerRe (PRE), a reinsurer, and Wendy's International (WEN), the fast-food chain, as good mid-cap value plays.

While liquidity is important for both small-cap growth and value investors, growth players need it more. "There is absolutely less liquidity in small-cap value stocks than in small-cap growth," says analyst Brad Lawson of Frank Russell Co. "But value investors tend to trade much less frequently. They don't need the liquidity."

One potential threat to the value story is a deep recession. But Federal Reserve Chairman Alan Greenspan is already signaling that he'll move to lower interest rates rather than risk recession. If that's the case, the takeovers and upward momentum of small-cap value stocks should continue.

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