Learning to Love the Little Guy

Small-cap value stocks are cheaper than big-company shares. Here are five that could pay off

As the pricey, mega-cap glamour stocks--Sun Microsystems (SUNW ), Intel (INTC ), Cisco (CSCO ), EMC (EMC ), Nortel (NT )--disappoint and portend a dim future, investors are rediscovering the charms of the small, the homely, the cheap. Of the 21 sectors into which the index keepers at Frank Russell divide the U.S. stock market, only small-cap value stocks managed to stay in the green this year, through Feb. 23. They were up 2%. Giant growth stocks? Down 9%.

Whether the trend will persist, I don't know. But companies with market caps under $2 billion remain relatively cheap--30% cheaper than big-company shares, when measured by their prices as multiples of cash flow, according to Merrill Lynch. "This universe has already priced in a recession," Satya Pradhuman, Merrill's main man on small caps, recently told institutional investors at a meeting put on in Florida by SunTrust Banks' $47 billion-in-assets money management arm.

I listened in on the conference, where 35 small companies pitched their stocks. These outfits do such mundane stuff as clear sewer lines and bake bread. Yet most of them are well established, with rising sales and profit, strong cash flows, and shares trading on the New York Stock Exchange. Here's five that caught my attention (table):

-- Baldor Electric. The leading maker of electric motors, Baldor hopes to exploit higher electricity prices. CEO John McFarland said that with half of U.S. electricity used to run motors, demand will grow for Baldor's variable-speed drives, which let motors run on less power at times. Also, Baldor last year branched into standby generators, aimed at customers who can't afford a brownout. Profit last year came to $1.34 a share--an 18% return on equity from a company selling at 15 times this year's expected profit.

-- Chemed. Few people know Chemed, but most know its largest unit, Roto-Rooter, famous for clearing blocked drains. Now Roto-Rooter is doing a lot more plumbing work, such as fixing leaky faucets. To get the word out, President Kevin McNamara said the company is tripling ad spending. It's also buying out franchisees. Earnings per share could grow 20% to 25%.

-- Earthgrains. Spun off by Anheuser-Busch in 1997, Earthgrains is a leading baker. It was coming on strong, both in sales and profit, until a strike in the current fiscal year, ending March 27, cut about 50 cents a share from profit, which figures now to come in around 60 cents. Chief Financial Officer Mark Krieger expects fiscal 2002 to recoup that and more, with net topping $1.50 a share.

-- Lennox International. This longtime air-conditioner maker only went public in 1999, at $18.75 a share. Late last year, it could be had for less than $7 and was recently near $12. CEO Bob Schjerven expects his move to sell directly to the retail market will soon start paying off. As margins grow, free cash flow may jump to $100 million from $60 million in 2000.

-- Pennzoil-Quaker State. The company dominates the U.S. motor oil market, with a 37% share, and the quick-lube business, with more than 2,100 Jiffy Lube outlets. By lowering costs and building sales of such higher-profit auto accessories as sunshades, CEO James Postl sees wider margins. His plan assumes crude oil at $34 a barrel, a key cost that's now near $29.

Will all of these stocks prove winners? I'd be surprised. But bread and motor oil look like better bets right now than servers and fiber optics.

Questions? Comments? Send an e-mail to barkerportfolio@businessweek.com or fax (321) 728-1711

By Robert Barker

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