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Stock pickers say it’s small caps’ turn

Updated: May 3, 2013 12:14PM

Originally published: August 1, 2007

The era of the stock picker has returned! At least, that’s the conclusion of four men who have made their reputations by picking stocks for themselves and their investment management clients.

Just when I’ve finished a three-part series on indexing, this panel of money managers declares that the era of index investing has seen its peak and that the real money will be made in the coming months by those who pick individual value and growth stocks instead of hitching a ride on the S&P 500 stock index.

The panelists at a DePaul University Business School conference panel last week included Richard Driehaus of Driehaus Capital Management; Lou Holland, managing partner of Holland Capital Management and well-known commentator on PBS’ ``Wall Street Week”; Rao Chalasani, chief investment strategist of Everen Securities, and Eric McKissack, portfolio manager of Ariel Capital Appreciation Fund.

The one subject on which there was unanimous agreement: small and mid-cap stocks are about to have their turn, and it would take insightful research to make money going forward.

Familiar refrain

Yes, we’ve heard this before, and up until now it has been wishful thinking. Surely it was the small and mid-cap stocks’ turn to move up long before now. After all, they’re the ones that can show big percentage earnings gains at this stage of the economic cycle.

The blue chips should have peaked in earnings growth, since they’ve already reaped the benefits of cutbacks and have little pricing power to lift revenues in these noninflationary times.

And surely those dot-com technology companies, which only dream of potential earnings, should have fallen out of favor by now.

Well, in the last few weeks, the small and mid-cap stocks have started to move. But the jury’s out on whether this is the start of a trend. For novice investors, we should point out that there are several schools of investment theory.

Growth stocks are driven by earnings and the expectation of future earnings. That creates a sort of momentum, which forces followers of this theory to continue buying stocks that already are moving up.

Value investors, on the other hand, look at the intrinsic economic value of the company to judge its potential as an investment. Even our panelists acknowledge that many measurements of value - such as the value of a company’s factory or equipment, related to its price - are woefully out-of-date. After all, the true value of a technology company is in the brains of its employees, not in its factories. Still, value investors disdain chasing after the promise of future earnings.

As for investing in companies that only have the prayer of future earnings, value investors don’t give them a second glance.

Which is probably why value stocks - and mutual funds - have mostly performed dismally compared with the S&P 500 stock index, which is weighted by large-cap growth companies.

How did the panelists fit these categories?

Noted Chalasani of Everen: ``I am a devotee of GARP: growth at a reasonable price. What I see today in the market is GAAP: growth at any price!’’

Still, he’s a definite fan of some technology companies, which he describes has having a certain intangible value. Thus, he likes America Online because of its franchise value, but he wouldn’t buy because its franchise value isn’t defensible against new entrants into the business and because it doesn’t have any pricing power. Similarly, he considers Eastman Kodak to be an example of a stock to buy under his GARP reasoning, but he says those buying Dell Computer must be following the theory of ``growth at any price.’’

Defining value

Lou Holland had a slightly different take on the subject. He questions AOL’s ``franchise value’’ - especially if cable provides a more efficient method of connecting to the Internet. But he’s also a believer that small cap stocks are the place to invest, if only based on the fact that they’ve lagged so badly. And among the laggards in both small and mid-caps, he favors the real value-oriented investments because of these divergences.

But you might be surprised at Holland’s definition of value. The stock he calls the ``world’s best company’’ is Microsoft. Selling at $78 a share, it’s down from its high of more than $95 and well off its low of $41 a share in the last 12 months. But that’s not what attracts Holland. He points to the company’s 40 percent net margins, huge free cash flow, investments in other technology companies that are carried at cost on Microsoft’s balance sheet, and what he calls ``conservative accounting.’’

Even though it’s selling at 58 times next year’s expected earnings (twice the multiple of the overall stock market), Holland calls Microsoft the one company every investor should own. And that just shows you how definitions of value have changed these days.

Driehaus, whose small cap funds have had outstanding performance in recent years in spite of the fact that the group has been out of favor, laid out the case for small cap investing. He noted that his managed small cap fund is up 161 percent through April 30 since the Oct. 8 bottom. That outperformed even the Russell 2000, which is up 40 percent from its October lows. Still, the Russell 2000 is up less than 6 percent for the year, trailing both the S&P 500 and the Dow Jones industrials.

Driehaus is particularly optimistic about small and mid-cap growth stocks, whose price; -earnings ratios are still ``very low relative to the larger cap market.’’ Driehaus points out these smaller companies are more insulated from any ongoing global economic problems, and he warns: ``Indexing is the ultimate trap. It boxes you into a corner, investing in things that are already discovered.’’

Among his small cap positions is a company called VISX, which makes the tools for the newly popular surgery to correct the vision problems that arise as baby boomers age. It’s these kinds of special situations that Driehaus figures will be able to build earnings, compared with the more well-known and mature companies in the large cap category.

Index has bias

Ariel Capital Management is known for its value style of investing, and its Capital Appreciation Fund turned in a 19.6 percent return last year in spite of its bias toward stocks that aren’t making headlines. Eric McKissack says the S&P 500 index doesn’t represent the stock market very well these days. After all, he notes, when the former Woolworth (Venator) was taken out of the index, it was selling at 14 times earnings. It was replaced by AOL, then selling at 40 times earnings. So the index itself has been manipulated to favor growth companies. McKissack would rather buy companies that he considers ``diamonds in the rough.’’ Among his choices are Hasbro, the toy company that is about to clean up on its ``Star Wars’’ products, and MBIA, which is a municipal bond insurer.

There was one other major point of agreement: Global growth will resume in 2000, and investors should have part of their portfolios in international stocks - especially in Asia, currently one of the most underappreciated sectors of the market. But that’s the subject of another column. We’ll track the performance of these and other small cap managers to see if 1999 really does turn into the year the small caps once again trounce the major indexes.

Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. You can send her questions via e-mail at savage@ Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.

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