A Macro View of Micro-Caps

Robert Sullivan's Satuit Capital Micro Cap Fund scores well with stocks of very small companies that have strong earnings growth

When investors make efforts to ensure that their portfolios are full diversified they should keep micro-cap stocks in mind. That's the advice of Robert J. Sullivan, portfolio manager of the Satuit Capital Micro Cap Fund (SATMX, who suggests that micro-cap stocks might represent 10% to 20% of a portfolio. Sullivan's advice is worth listening to, considering his fund has scored a 17.58% return this year as of Dec. 15.

Satuit Capital Micro Cap invests in companies with $500 million or less in market capitalization, with 83 names in ownership now. Sullivan says he shops for companies that are reasonably valued and offer above-average growth in earnings per share. Among its best recent performers he cites Orbit Technologies (ORBT ), which makes customized electronic components.

Sectors Sullivan likes in micro-caps include energy, health-care, telecom, and telecom services. In the energy sector, he leans toward the exploration and production group, including Brigham Exploration (BXEP ) and St. Mary Land & Exploration (SM ).

These were a few of the points Sullivan made in an investing chat presented Dec. 16 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Amey Stone of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a complete transcript at keyword: BW Talk.

Q: Bob, as we approach the end of the year, how does the broad market look from your perspective?

A:

The market in general, like the rest of the country, has gone through an incredible year in 2004. If we look at the continued conflict in the Mideast, oil prices skyrocketing to the levels that they got to, a Presidential election that was acrimonious at best -- all of these things standing in front of investors in both the fixed-income and equity markets certainly provided a very steep hill for all of us to climb, the capital markets in general.

But coming toward the end of the year, we're certainly seeing some solid movement on the upside in the indexes, and we think that will lead us into a pretty solid 2005.

Q: Can you tell us a little about your fund and investment style?

A:

Sure. The Satuit Capital Micro Cap Fund focuses on companies that are $500 million of market cap or less. The philosophy is that companies that are trading at a reasonable valuation with an above-average earnings-per-share growth rate are companies that will outperform over the long haul. The investment process involves looking at companies on a case-by-case basis -- bottom up, fundamentally driven investment analysis -- and trying to understand four things: the driver of revenues, the driver of margin expansion, the driver of balance-sheet strength, and the driver of cash flow.

Q: As an example, what have some of your best recent performers been?

A:

Well, let's take a look at one that has been perfoming quite well over the past week, a company called Orbit Technologies. Orbit designs and manufactures customized electronic components, and buyers are typically larger companies with contracts to the U.S. government.

Q: How many companies are in the fund, and what's the return on this fund year to date?

A:

Typically, we hold between 70 and 100 securities in the portfolio. Currently, we hold 83 positions, and our year-to-date return as of Dec. 15 was a positive 17.58%.

Q: What kind of turnover does your fund have?

A:

The turnover of the portfolio for this year, ended Oct. 31, will be around 150%. In 2003, the turnover was 149%. In 2001, it was 123%. Those turnover numbers are pretty much in line with this type of fund.

Q: Can you tell us more about the sectors you're emphasizing or underweighting in your portfolio?

A:

Well, we're underweighting financials, and let me talk a little bit about the financials in the micro-cap world -- they're typically your small bank, 10 to 20 branches, and are going to be borrowing short-term funds, lending out long-term funds, and when interest rates start to tick up, you'll start to see a margin squeeze in those types of banks.

We're somewhat overweight in energy. I think that the long-term secular drivers will keep commodity prices high enough that capital spending by the larger exploration and production (E&P) firms will help the suppliers of services. We've moved somewhat to an overweight position in telecom and telecom services, and we're typically somewhat overweight in health care.

Q: What's your exposure in the E&P area?

A:

A couple of E&P names include Brigham Exploration (BEXP ) (58% natural gas production, 42% oil), also St. Mary Land & Exploration (SM ) (85% exposed to natural gas). Another interesting name that's in the energy patch that's outside of E&P is Dril-Quip (DRQ ). They design and manufacture drilling equipment. Worldwide oil production is expected to grow over the next few years, and you'll certainly need to have wellhead and drilling equipment to do that -- an interesting way to diversify your holdings in the energy patch.

Q: A broad question for you -- what types of fund will perform well next year?

A:

Well, certainly SATMX will perform well next year -- I hope. But more seriously, as a professional investor, I get this question all the time, and I answer it in terms of modern portfolio theory. I don't think the question should be "what funds or stocks or bonds or markets will perform for us next year?" but rather "Is my current portfolio invested in such a way that I'm able to capture as much of the upside in any market that we face next year, and limit my downside?"

I ask myself if I'm fully diversified among all asset classes, and in equities specifically, do I have exposure in large-cap, mid-cap, small-cap, and micro-cap [holdings]? If I am, chances are I won't have to worry about upmarkets or downmarkets. I may have to tweak my positions occasionally, to reflect what I think the markets will do over the next 12 to 18 months, but the diversified portfolio will outperform the nondiversified portfolio.

Q: Which nanotech stocks do you find worthy? If any, that is.

A:

We have not made any investments into the nanotech stocks, although it is a space that I've done my homework on. Most of the companies in that space don't have the fundamentals that we require for this particular fund.

Having said that, it's a terrific space to troll and to find some good investment ideas. One of the criteria that I'd certainly look at is the balance sheet, to make sure that I had enough cash for my burn. In a lot of ways, some of these companies with their technologies are much like a biotech firm with a product in development that needs to go through four or five years of testing and approval before final product.

Q: Is your fund in any interesting small biotech or pharmaceutical companies?

A:

The Satuit Micro Cap Fund is not heavily involved in the biotech space. The investment philosophy and process for the fund tries to focus in on companies with positive earnings. Having said that, we have at times invested in the space but currently do not own any of those "pure" biotech-type firms. An interesting holding in the fund is SFBC International (SFCC ). They provide Phase 1 and Phase 2 services, data management, and statistical evaluation for the biotech industry. So while we're not directly involved in the biotech R&D industry per se, we're involved in a company that helps the biotech world bring their drugs through the Food & Drug Administration testing process.

Q: How can the average investor best find reliable opinion on micro-cap stocks?

A:

One of the first places that I go to for information regarding the companies I'm looking at is their Web site. Web sites have leveled the playing field for all investors. I can go there and look at the company's products, find out who their suppliers are, who their customers are, who their managements are. And in most cases, in the investor section, I can listen to replays of not only quarterly conference calls but industry conferences and events that the management has spoken at.

The second place I'd go is www.sec.gov and pull off the 10-Qs and 10-Ks of the companies. With those two resources, an investor is certainly armed with enough information to begin really digging into the investment attributes of a company.

Q: What about Wall Street research? Do you find that the big firms are covering fewer companies since the scandals of the past? Or did they never really follow the companies you invest in?

A:

Typically, the companies I invest in have at least one analyst following them, and that could be from a major Wall Street firm or a regional firm. What I always found interesting from a larger firm when I called on one of these smaller companies is that they enjoyed talking about them, because they've had to follow them with nobody ever asking about them. The smaller regional firm is excited because they may not get any calls at all on a name.

The other interesting thing to note on investing in small companies is your access to the actual decision-maker of the company. Larger firms tend to have bureaucracies of investor relations. Smaller firms, you can talk directly to the CFO, the CEO, and even the chairman of the board. One of the difficulties that has always been inherent in small companies and research is that brokerage firms don't follow them because of lack of investment-banking dollars.

Q: What's your opinion on the gaming stocks?

A:

Typically, the gaming stocks have been a bit out of our market-cap range. We tend to look at the smaller retailers in the space -- for example, a holding in the fund now is GameStop (GME ). GME, being a retailer, will benefit from the demand for games like Grand Theft Auto, like Halo 2, like Game Boy, and not generally dependent on one huge title smash. They'll benefit as long as there's interest in gaming in general.

Q: What do you think of stock valuations in general? Small-caps have had a good run. Do you worry they could be getting overpriced?

A:

The quick answer is no, I do not at this point worry about valuations as much as I did back in February. At that point, we had rallied off a 2003 low, and prices had exploded, while earnings had not caught up. Over the balance of 2004, what we saw was earnings catching up to prices, and while small companies as measured by the Russell 2000 are at historic highs, I don't necessarily think there's a valuation issue relative to small- and mid-cap.

To drill down a bit further, the universe of companies that I look at -- at $500 million of market cap or less -- ranges between 3,000 and 5,000 companies, depending on the level of the general marketplace. It gives me the opportunity to find those companies that are reasonably valued and have an above-average earnings-per-share growth rate -- the law of large numbers. Simply put, in the world of smaller and micro-cap companies, there's just more to look at.

Q: Have you had any success stories in the form of micro-caps that grew up to be one of the big boys?

A:

Yes, there have been quite a few companies that we have owned along the way that have started out at $350 million of market cap, moved up into $700 million of market cap, and at that point the small company funds will take a look at it and start buying it up. Once that happens, we tend to sell into that strength, as we do try to stick to our guns and invest in those companies that are $500 million of market cap or less.

One company in particular stands out in my mind, Ceradyne (CRDN ). They're a maker of ceramic inserts for bulletproof vests for law enforcement and the military. We owned that at $4 a share, and over the course of time had to sell out of it because it went from $120 million to $800 million in market cap, where it is today.

Q: In allocating assets, what share of a portfolio would you recommend for micro-cap stocks?

A:

Based on the historical work that we've done, if you believe that a diversified portfolio will outperform over the long run, at minimum a 10% allocation and a 20% allocation maximum.

Edited by Jack Dierdorff

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