3 Tools for Small-Cap Success

Tom Gardner receives dozens of questions each week about hisHidden Gemsinvesting philosophy, one that is soundly beating the market. Fellow Gems team member Rex Moore recently pulled together the most common questions for an interview with Tom.

This is the fourth of a five-part series. Other installments are linked in the box at the right of the page.

Rex: Do you make any attempts to predict the short-term course of the market?

Tom: Not for the short-term, but I do think that you can get a sense of fair-value ranges for the intermediate- to long-term. Here are three tools that I think are useful.

The first comes from Peter Lynch. He essentially suggests that you look at the P/E ratio attached to the Russell 2000 (a small-cap index) and compare it to the P/E ratio of the overall market. Lynch said basically when small caps are trading at a multiple that is 1.2 times that of the overall market or less, then small caps are a very attractive investment. But when small caps are trading at an earnings multiple that is 2.0 times that of the average market or greater, then it's time to start getting out of small caps. Right now the multiple is about 1.3, so I still think small caps are a pretty attractive place to be. When the ratio is not attractive, I'll begin reducing my exposure to small caps in Hidden Gems, and recommending mid caps.

The second useful statistic is to look at the number of initial public offerings (IPOs) per month. If you had simply tracked the number of IPOs in the late 1990s relative to the average number of IPOs in the 10 years previous or in the 20 years previous, you would have seen a tremendous number of new companies coming public. That is telling you two things. First, private companies want to sell out of some of their stock. Essentially, they think they can get a very attractive valuation, which may not represent a great future valuation for the buyers of that stock!

The second thing that monthly IPO counts tells you is that, as that number rises, there are more and more companies out there in the public markets competing for investor dollars. So were you to double the number of public companies in America tomorrow morning from 10,000 to 20,000, that would have the effect of diluting investor returns. The wider the group of investment options for equity owners, the lower the return. So IPO counts is a good way to follow indirectly the general direction of the market.

A third tool is just to follow what insiders are doing. In Hidden Gems, we had a wonderful interview with Dr. Nejat Sehyhun from the University of Michigan. He talks about aggregate insider trading. In the late 1990s, there was a ton of insider selling. Conversely, on Oct. 20 of 1987, the day after the massive one-day market crash, there was a tremendous amount of insider buying. Those can be wonderful indicators of returns over the next five years.

Rex: Are there any sectors or industries that you like. Or do you blindly work from the bottom up?

Tom: I do spread my investment recommendations broadly, but I also look closely at the demographics and trends in America and around the world, with an eye toward what products and services will gain traction over the next 15 to 20 years.

That's led me to a focus on health care and medicine. Over the past few years, I've found some very attractive investments there: Quality Systems (Nasdaq: QSII  ) , United Health (NYSE: UNH  ) , Lab Corp (NYSE: LH  ) , and Possis Medical (Nasdaq: POSS  ) . For the past few years, I've been steering clear of the large pharmaceutical companies because I am not sure what's going to happen with the rising threat of foreign generic drugs being sold in the U.S. I see that large area of the health-care industry as being at risk. When you look at prescription drug prices and the margins these companies are generating, it seems pretty obvious that the system is going to change over the next 10 to 15 years.

Offhand, a lot of consumers are frustrated with their HMO. But when you really look at how the overall industry is working, your HMO is making five cents on the dollar after taxes. Very tight margins. It's your pharmaceutical company, a company like Pfizer (NYSE: PFE  ) , that is making 30 cents on the dollar after taxes. I know Pfizer has to generate a lot of cash to fund its research and development for future drugs. But I think that when society looks at this industry and tries to figure the best way to get efficient and effective health care to baby boomers and retirees, I think they are going to look at the large pharmaceutical companies and ask whether there shouldn't be a change in the regulatory structure on how drugs are researched, developed, delivered, and priced in the marketplace.

So I've stayed away from pharmaceuticals, and it's an area of this industry that has done very poorly over the past few years. Historically, some of the drug companies are looking cheap. But I'm worried about the impact of regulatory changes on their future cash flows.

Conversely, I do think medical technology and hospital facilities and in-home care and all of the advancements in the high-margin business of cardiovascular treatment are areas of opportunity. Furthermore, I believe in the future of preventive care, better eating habits, regular exercise (the emergence of the in-home gym), etc. There will be compelling commercial opportunities here. As much as I deeply admire Warren Buffett's investment approach, I don't think his eating habits (Dairy Queen, Cherry Coke (NYSE: KO  ) , and See's Candies) reflect where the baby boomers are going.

So, in those areas, I think there are very interesting investment opportunities over the next 10 to 15 years. Now, I have found it a little difficult over the last half year to find attractive valuations across the market, but that is definitely changing in the past eight weeks.

Tom's average returns in Hidden Gems are well ahead of the market. A no-risk,free trialgives you access to two selections each month, plus the complete Gems archives.

Tom Gardner owns shares of Pfizer and Coke. The Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 493415, ~/Articles/ArticleHandler.aspx, 10/1/2014 6:35:45 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement