Online Extra: Where the Sweet Small-Caps Are

Buffalo Small Cap's Robert Male says the sector's best days may be over, but he's still find attractively priced plays

Robert Male, co-manager of the Buffalo Small Cap fund, is a trend spotter. To find companies for the $1.6 billion small-company growth fund, Male and his colleagues have identified 20 long-term trends. "Unlike a theme, trends have to be very predictable," he says. One of the portfolio's most dominant demographic trends is the aging of baby boomers, which has led Male to invest in health care, retailers, and other companies that cater to older Americans.

Such bets have paid off -- the fund tops the performance charts for the past five years, with a 22% annualized gain. BusinessWeek Personal Finance Editor Lauren Young recently spoke to Male about the small-cap market, demographic trends, and the education sector. Edited excerpts of their conversation follow.

Q: We've had a great run in small-caps in the past five years. Can it continue?


I'm not going to sit here and tell you valuations are as compelling as they were last year relative to large caps. If you go back over history and look at the valuation of the small-cap indices on p-e basis relative to large caps, the current p-e for small-caps is about average.

That means small-caps aren't overly expensive. But they aren't overly inexpensive. Even so, looking at our portfolio we see tremendous top-line and bottom-line growth. We're still finding stocks that are attractively priced.

Q: Where are you finding them?


We're finding them in retail, we're finding them in technology, which has come off since first of year, and we're finding them selectively in health care.

Technology has sold off. It did very well in 2003. While we trimmed it back before the end of the year, we didn't sell out of tech totally. Then the market rolled over. You had a lot of momentum players getting into these stocks. They saw a little deceleration in growth rates, and they got out. It was especially bad for semiconductor and semiconductor-equipment companies.

Q: That's a cyclical business. Did it correct because of the business cycle or because of valuations?


While you saw a deceleration in revenue and earnings in some areas, you also saw a pick up in the first quarter in inventories. The first quarter is seasonally the slowest part of the year, so we didn't think it was too alarming.

We feel that the fundamentals are going to improve in second half of the year. Even better, prices continue to go up. We believe there will be continual capital spending increases, and inventory levels will come down.

Q: What about small-caps in general? Are the fundamentals still good?


We've seem significant growth in revenues. During the first quarter, revenues of the companies in the fund grew 15%, while the typical stock in the portfolio is showing earnings per share growth of 22%. That's very good.

That said, we know that oil is $40-plus dollars a barrel, which is high. As the economy continues to improve, interest rates may move up. I don't think they will spike up, but they could move up.

Q: You mentioned that semiconductor companies are raising prices. Are you seeing pricing power anywhere else?


We're seeing it in health care. That's one area that's always had pricing power. But we're also seeing it in retailing. This quarter, for the first time in a couple of years, I've seen a move up in apparel prices. That's good for the retailers, and it's a big change.

Q: Does that mean you like the retailing sector?


In the retail space, J. Jill (JILL ) is one stock we like. It's a multichannel retailer. It started out as a catalog operator, and they did well in the catalog space. If you look at catalog companies, typically their operating margins are between 5% and 6.5%.

J. Jill sells to 35- to 65-year-olds. Their median customer is 50 and has an average household income of $100,000 or more. If you look at a demographic group that's growing, this is it. They're selling into the sweet spot. That's how J. Jill made it through our trend screen.

Historically, it has been a catalog company. Now it's opening retail locations. If J. Jill does it right, margins can go from 6% to 14%. I use 14% because Talbot's (TLB ) has the same mix, and that's their operating margin.

J. Jill can fund all their growth internally, through free cash flow. Last year, they realized they need to combine the database for catalog and Internet customers. They also realized their color palette was too narrow -- but they had seen retailers change merchandise which angered the customer base. However, they needed to move from muted colors to more colorful ones to attract new customers, so they did it. Guess what? Comparable-store sales (those for stores open at least a year) gained 24% in the first quarter. The stock has gone from $12 to $23.

One other reason we like J. Jill is that it only has 126 stores, with the potential to grow to 500 stores. The penetration of J. Jill is in its infancy. They can grow stores with internal cash flow. You have the opportunity to expand margins from 3.4% to 14%.

The other thing that's good about the company is the management. J. Jill brought in 17 new people just recently. Some of them came from Gap (GPS ) and Banana Republic. They have significant room for improvement and upside in stock.

Q: What are you avoiding?


We've been avoiding anything to do with oil because those companies aren't predictable. You don't know what the price of oil is going to be tomorrow.

We did sell out of all our education names. We had a significant weighting, nearly 15%, in companies like ITT Educational (ESI ) and Strayer (STRA ) -- we owned almost all of the education companies. They did wonderfully for us. We thought they were getting expensive, and we sold them. We only own DeVry (DV ) now. It's more attuned to the turn in tech spending than the other ones.

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