Small-Cap Picks That Could Lead the Way

The past year hasn't been kind to small-cap growth investors like H. Giles Knight, portfolio manager of Ark Small-Cap Equity Fund. It's down 9.9% through Dec. 14, though its five-year risk-adjusted return merits an A from the BusinessWeek Mutual Fund Scoreboard. Knight looks for the economy to recover in 2002 and small-cap stocks--growth as well as value--to assume their traditional role of leading the way.

Knight searches for companies with market caps from $50 million to $1.8 billion. Then he pares the list to those with revenues growing a minimum of 15% a year, earnings at least 12%, plus a return on equity of 15% or more. He weeds out those with debt that's more than 30% of capital. He then sizes up management.

Of Knight's 10 picks, two are in the semiconductor industry--usually the earliest beneficiary of increased tech spending. In fact, Knight calls one of his two chipmaking-equipment picks, Kulicke & Soffa Industries Inc. (KLIC ), a "canary in the coal mine," meaning it's first to die--or to revive with the economy. Axcelis Technologies Inc. (ACLS ) is his other choice. Another economic-recovery pick is Pride International Inc. (PDE ), a Houston oil-exploration company, since a healthier economy should lead to higher oil prices.

He's also betting that the war on terrorism will bring a long-term increase in defense spending. To that end, he chose two companies that service the aerospace and defense industries, Teledyne Technologies Inc. (TDY ) and Alliant Techsystems Inc. (ATK ) A somewhat contrarian play is SkyWest Inc. (SKYW ), a Utah-based regional airline whose stock he thinks will take off as travelers return to the skies--and major carriers cut back service to smaller cities that regionals can serve.

The rest of Knight's picks span a number of industries. Medical-supply maker PSS World Medical Inc. (PSSI ) is looking for revenue growth from higher insurance-reimbursement rates. The stake in CKE Restaurants Inc. (CKR ), which operates some 3,800 fast-food restaurants, should fatten under new management. His bet on Alliance Gaming Corp. (ALLY ), which makes casino equipment, is based on its expansion into new products. XM Satellite Radio Holdings Inc. (XMSR ) will sing, he believes, as subscriptions to satellite radio programming catch on.

By Carol Marie Cropper

Before it's here, it's on the Bloomberg Terminal.