FOOL ON THE HILL
Think Small Companies

An individual investor's greatest advantage is being able to buy illiquid stocks that money managers can't. Small-cap stocks are especially attractive today, with so few bargains available among blue-chip stocks.

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By Whitney Tilson
March 27, 2001

Last year around this time, it was a fabulous time to be a value investor. With the Nasdaq breaking 5,000 and the herd fixated on tech stocks, the rest of the market was being ignored, creating many wonderful opportunities in attractive sectors like insurance, consumer products and pharmaceuticals.

Some of the world's great companies were available for good -- if not give-away -- prices. Examples included Berkshire Hathaway (NYSE: BRK.A) at $41,000, Pepsi (NYSE: PEP) at $30, American International (NYSE: AIG) at $52, and Pfizer (NYSE: PFE) at $30.

Unfortunately, these bargains have largely disappeared. As investors have fled the tech sector -- which I believe still remains perilous -- they have moved money into other sectors such as those noted above, eliminating the bargains. Even "low-P/E" stocks have been bid up, such that they trade at 1.2 to 2 times their historical P/E ratios, according to William Bernstein, an investment advisor in North Bend, Oregon.

Thus, with the exception of Berkshire Hathaway -- which I already own -- I cannot find a single large-cap, blue-chip stock that really gets me excited, with the possible exception of American Express (NYSE: AXP), which is trading at a price not seen since March 1999 (and at a P/E ratio not seen since Warren Buffett last added to Berkshire Hathaway's position in 1998).

Speaking of Buffett, he shares my pessimism about valuations today, noting in his recent annual letter to shareholders: "Really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point."

So what's a value investor to do? In Buffett's case, due to the size of Berkshire Hathaway, the answer is to look to buy companies outright (but mostly sit on cash and bonds). However, I -- and most readers of this column, I suspect -- have a better option: think small. Given the relatively small size of our investment portfolios, a few thousand dollars -- or, at most, a few hundred thousand dollars -- is a material position for us, so we can buy even the most illiquid stocks that most money managers can't even consider.

Buffet himself recommended at Berkshire Hathaway's 1999 annual meeting that small investors focus on obscure companies: "If I had $10,000 to invest," he said then, "I would probably focus on smaller companies -- because there would be a greater chance that something was overlooked in that arena.

"There are little tiny areas where if you start with [the letter] A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there's an opportunity to earn very high returns.

"I could name half a dozen people that I think could compound $1 million at 50% per year. But they couldn't compound $100 million of $1 billion at anything remotely like that rate."

The argument for focusing on obscure companies makes a great deal of sense intuitively. Do you think a stock is more likely to be mispriced if only a few people have ever heard of the company and not a single analyst follows the stock, or if the company is a household name, with dozens of analysts covering the stock? (Before you email me to argue, I'm aware that for a number of years, ending only recently, one could simply buy the most popular stocks and laugh all the way to the bank -- but those days are over.)

Where to begin looking
Of course, it's easy to say that obscure stocks are good places to look for bargains, but such stocks by definition tend to be hard to find. So where should you begin looking? I read a lot and sometimes find undiscovered gems this way, but I get most of my best ideas from fellow like-minded investors. A marvelous website that contains a community of such investors is Value Investors Club, of which I am a member.

I have posted one idea, Imperial Parking (NYSE: IPK), which is among the largest parking lot operators in North America (and is one of my largest holdings). The company dominates the Canadian market, in which it has operated since 1962, with approximately 50% market share. It is growing rapidly, has a solid balance sheet and high returns on capital, and I believe it has the best management team in the industry. (I posted a more detailed analysis on the club's website.)

Friends of mine have submitted other ideas to Value Investors Club, including Autozone (NYSE: AZO), Blyth (NYSE: BTH)Criimi Mae (NYSE: CMM), and Huttig Building Products (NYSE: HBP). Three other interesting ideas I discovered on the site, but which I haven't had a chance to analyze fully yet, are Tractor Supply Company (Nasdaq: TSCO), Galileo International (NYSE: GLC), and Handleman Company (NYSE: HDL).

Note that some of the stocks on the site are priced below $5/share (including Huttig) and some are below $1/share, such as Criimi Mae. As The Motley Fool has correctly pointed out time and again, such low-priced stocks are often extremely dangerous and subject to manipulation, scams, and the like. However, for some of these same reasons, on rare occasions one can find attractive and significantly mispriced stocks. I recommend viewing stocks priced below $5/share (and especially $1/share) with a great deal of skepticism, but to unequivocally rule out such stocks simply because of their price would be just as foolish as refusing to buy Berkshire Hathaway because its price is so unusually high.

As you can tell, I think Value Investors Club is a rich source of interesting investment ideas. Visit it soon, however, as it will only be open to members after April 6th (it was supposed to close to the public on April 1st, but I asked the site to move this date so readers of this column would have sufficient time to visit it).

[The Motley Fool discusses small-cap investing in its Foolish 8 area every week.]

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway, Imperial Parking, Criimi Mae, and Huttig Building Products  at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, visit http://www.tilsonfunds.com.