FOOL ON THE HILL: An Investment Opinion
Hunting for Diamonds

It's easy to forget that big, successful companies usually start as small companies with all the basics in place -- low debt, good earnings growth and cash flow, and high returns on equity.

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By Richard McCaffery (TMF Gibson)
October 26, 2000

Last week, Forbes published a list of the 200 best small companies in America, a list that included the names of companies that make card shufflers, non-wood deck products, and sprinkler irrigation systems.

I like lists like this for a few reasons. First, it's fun to pore over lists for investment ideas. Not investments, mind you, but ideas -- rocks to turn over. The diversity of businesses in this free market economy of ours is amazing, better than Baltimore's Lexington Market for variety and ingenuity.

Second, not every company can participate in the slickest industries. Fortunately they don't have to. There are plenty of companies that found niches or caught a profitable wave far removed from the turbulent world of the Internet, customer relationship management software, or fiber optics. In 1995, who would have thought JAKKS Pacific (Nasdaq: JAKK), which makes action figures and other toys, would return 52% annually for the next five years? Thanks to the soaring popularity of the World Wrestling Federation (NYSE: WWF), Jakks' wrestling figures sell faster than George "The Animal" Steele could pin "Stone Cold" Steve Austin.

Finally, in an age when a company with no revenues can secure a billion-dollar market value, it's fun to look at a group of growing companies whose stock prices have more to do with business values than crystal balls.

I like small companies since it's easy to lose sight of reality with big numbers. Every now and then I have to remind myself that most companies aren't capitalized the way AT&T (NYSE: T) is, for example, with its $32 billion in long-term debt relative to $71 billion in shareholder's equity. Through the first six months of 2000, AT&T paid $1.2 billion in interest alone.

Or look at General Electric (NYSE: GE), the behemoth with a market cap of more than $500 billion. It's the biggest company, as measured by market value, in the S&P 500 by a long shot. Runner-up Cisco (Nasdaq: CSCO) has a market value of roughly $350 billion.

These kinds of companies of course aren't representative of the S&P 500, which has a median market value (the mean value places less emphasis on extreme values) of just $8.3 billion.

Seeing the kinds of companies that made the Forbes list reminds me how much value lurks below the radar screen for investors willing to dig.

One theme that emerges as you look through the list is what I'd call the blue-chip slipstream: companies that found a groove in the wake of big business and slipped in.

Look at the ride AAON (Nasdaq: AAON) hitched when it started manufacturing and marketing rooftop air conditioning and heating equipment. A humdrum business, right?

The company, which had $128 million in sales last year, has about 10% of the rooftop commercial HVAC market. Fast growing Wal-Mart (NYSE: WMT), Home Depot (NYSE: HD), and Target (NYSE: TGT) accounted for 23%, 8%, and 8% of sales in 1999, respectively. Since 1992 Aaon has returned 37% annually with dividends reinvested, generated a 33% return on equity last year, and carries just $6.6 million in debt, down from $11 million last year. It has grown earnings 41% annually for the last five years and trades at a forward P/E of 11.4.

ASI Solutions (Nasdaq: ASIS) is another company in the Fortune 500 slipstream. Companies such as American Express (NYSE: AXP), Verizon Communications (NYSE: VZ), and Hewlett-Packard (NYSE: HWP) outsource human resources operations to ASI, which has grown sales at an average rate of 35% over the last five years. ASI also has a clean balance sheet with no long-term debt, and earned a modest 14% return on equity last year. Verizon accounted for 28% of sales in 1999.

Finally, consider Bright Horizons Family Solutions (Nasdaq: BFAM), which provides child care and early education services for 68 of the Fortune 500 companies. Bright Horizons, like ASI, has seen its ROE slip in the last year and is pricey on a P/E basis relative to the others I've mentioned, but the company has grown earnings 21% over the last five years, carries almost no long-term debt, and generates about twice as much in cash from operations as it reports on the bottom line.

None of this means these companies are worthy of investment. Finding investable ideas is the hardest part of investing, and requires more than screening a handful of corporations for decent ROEs and high earnings growth. But hunting through the small-cap bins for up-and-coming players hones the investment skills, and every now and then you might find a diamond in the rough.