Counting on Another Tech Tumble

Daniel Szemis of the Merrill Lynch Small-Cap Value fund is hoarding cash in anticipation of a fall sell-off

By James A. Anderson

His fund is blazing -- up some 20% this year. And he's invested in one of the few portions of the market you could call smoldering. Still, you might be surprised that portfolio manager Daniel Szemis is hoarding cash right now.

Szemis, who already has $2.2 billion in assets spread across four share classes of his fund, Merrill Lynch Small-Cap Value, isn't standing pat to give his competition a chance to catch up. He's socking away some $400 million he picked up from selling stocks with big gains this year because he spies a nice buying opportunity in the not-too-distant future, especially in the tech sector.

His thinking: because 2001 has been full of earnings shortfalls and stock drops, a fidgety troupe of institutional investors is likely to get very nervous and dump stocks in September or October. Some will quiver in a last-ditch attempt to earn a performance-based bonus. Others will get squeezed by capital-gains taxes. No matter. The autumn sell-off is usually a dandy time to step in and sweep up bargains -- and this year, that should be especially true. Don't look for Szemis to be among the forced sellers, particularly with the kind of year he's having. According to Morningstar, Merrill Lynch Small-Cap Value (MBSPX ) (a member of the BusinessWeek A-list) put up a three-year average annual return of 21.3%, almost 18 percentage points more than the S&P 500 over the same period. The Merrill fund's five-year annualized 18.3% return is no slouch, either.


  Maybe it shouldn't be surprising that Szemis is having such a good 2001. The Russell Value 2000 -- a tabulation of the market's cheapest-valued small companies, the kind Szemis might gravitate toward -- was up 11.1% for the year up to Aug. 23. Still, Szemis and his team of six analysts deserve a good deal of credit. Their 19.7% total return so far in 2001 is 31 points beyond the S&P 500 -- enough to plant them in the top 7% of all small-cap funds in their category, according to Morningstar.

Szemis has a battered tech market to thank for much of his recent success. A top holding, Tech Data (TECD ), a distributor of computer hardware and a stock that has taken up 3% of the Merrill fund's assets, is up 25.3% in 2001. Another holding, Anixter International (AXE ), which distributes computer and networking equipment and has constituted 2.3% of the fund's assets, has climbed 39.1% year-to-date. And Network Associates (NETA ), a stock where 1.8% of the fund's assets have been invested, has ballooned 257.9% so far this year.

Small tech stocks might be due for a spurt, too. Prudential Securities Small-Cap Research Director Steven DeSanctis says that growth stocks within that segment have lagged miserably in 2001, dropping some 3.8% year-to-date as of the close of trading Aug. 22. "We've seen some value managers head into what would normally be more 'growthier' stocks of late," he says. "Tech shares are certainly beginning to show up on the value radar, and could be due." Szemis must think so: His fund carries a 20% weighting in tech, vs. a 14% position by the Russell 2000.


  Szemis says his stock-picking technique is relatively straightforward. He starts with a pool of companies with a market capitalization between $200 million and $2 billion. He throws out candidates that don't trade at least 2 million shares of stock a day. The next step is to apply a few screens to sift through pricing and valuation data and dig up stocks that are trading at the bottom 20% of their historic price-to-book valuations or enterprise value to sales. Under current conditions, says Szemis, maybe 500 companies fit all his criteria.

As a final pass, there's a check for relatively debt-free balance sheets. Szemis & Co. also look into a company's business and poke around to see what has been eating at its shares. Sometimes, he says, it's a sea change in the business. In that case, the stock gets thrown out. Or it may be that a company lost one big customer and is temporarily reeling. Szemis says that's interesting enough to make him probe further. He'll pick up on stocks that have been socked by bad news, earnings miscues, or market sentiment that their sector is hurting. Just as long as the company is hindered by what he terms a temporary event, such as the loss of a key customer, a momentary slowdown, or a regulatory snag.

In the end, Szemis says he's looking to settle in on some 150 holdings he can hang on to for two years or so. That kind of faith keeps his fund's turnover to a fairly modest 42%, compared to the average of 121% for his peers in Morningstar's group of small-cap blend funds.


  Given his stock-picking technique, it's clear why Szemis has a sweet tooth for tech: The sector fits his profile perfectly. The industry has filled the newspapers with bad news. Investors have grown cold on companies in that part of the market. And finally, tech stocks have dropped considerably in price.

Right now, a tech favorite of Szemis' is Entrust (ENTU ), which supplies industrial-strength access, control, and encryption software, just like RSA Security (RSAS ) or Verisign (VRSN ). Entrust couldn't avoid the Web meltdown, and tumbled to an Aug. 23 close of $3.85 a share, far below the lofty $150 it commanded in March, 2000. At that price, it sells at just under 70% of revenue estimates for the coming year, vs. the average 400% a typical security-software firm might get, says Szemis. "We think companies in this segment of the market will see 25% annual revenue growth when the market recovers," adds the fund manager, whose 18-month price target for the stock is $10.

Another pick, medical-device maker Novost (NOVT ), hasn't panned out yet. Szemis says the stock worked well for him two years ago, when he bought at $18, and then sold his stake at an average of $42 a share the next spring. Szemis felt the stock was due for another run, and, early last fall, started buying again at an average of $25 a share.


  In March, however, when clinical tests for a new treatment the company was working on failed to deliver overwhelming results, the street hammered Novost, which ended the Aug. 23 trading day at $15.80. Szemis says the company's markets should nonetheless prove resilient, and that other device makers, such as Johnson & Johnson (JNJ ), Boston Scientific (BSX ), and Medtronic (MDT ) might be tempted to snatch up the company at its depressed price. He thinks Novost could return to the $30-a-share range in the next year and a half.

Beyond the coming hunting season, Szemis thinks things look good for small-cap pickers like himself. He likes to point out that historically, small-caps have bounded some 38% upward during the 12 months after the Federal Reserve cuts interest rates a fourth time. During this latest round of slashing, the small-cap group has only picked up 2% since the Fed's fourth adjustment on Apr. 18. "Small-caps tend to be the best performing category during rate-cutting cycles, and we still haven't made much headway," says Szemis. "That makes me rather optimistic." Happy hunting.

Anderson teaches journalism at the City University of New York. Follow his twice-monthly Mutual Fund Maven column, only on BW Online

Edited by Patricia O'Connell

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