[This Fool classic was originally run on December 3, 2001.]
My five-year-old niece is a card shark. She'll be playing a game, when suddenly, boom, the rules change. Fives will become aces. Deuces will be wild. She just can't lose. It's not fair play but if she just flat out doesn't like the hand she's been dealt, she will change the terms of the deal. If my niece was publicly traded, she would be a large cap living la vida pro forma.
Now, I'm not saying that small caps are immune from blurring-bottom line results. We both know that it's easier to pull off shenanigans in the shadows of Wall Street than in clear view. However, it is the large caps who will often be tempted to sweep net profits under the fiscal rug and use things like acquisitions and bloated debt levels as a crutch.
I'm not sure who the first person was who fell for the EBITDA (earnings before interest, taxes, depreciation, and amortization) gauge hook, line, and stinker. The acronym probably originally stood for Every Bad Income Trick Deserves Appreciation. I imagine the exchange probably went something like this:
Company: Hey, we've really been on a buying spree lately. We'd like to restate our earnings to exclude the amount that we spent on our acquisitions.
Company: Yep, so let's forget about amortization and depreciation for now and move on, shall we?
Analyst: Forget the earnings from the acquired operations, too?
Company: Oh, goodness no! Have you gone daft? We'll want to keep that. And, while I have you here, I want to have the freedom to run our debt-levels as high as possible without ever being held accountable for the borrowing costs.
Analyst: I don't like that. You're sidestepping the accounting markdowns for money spent in the past, but now you want to ignore actual debt payments in the present. No one will buy that?
Company: That might be true, but did I mention that we were looking for an underwriter to handle our upcoming debt offering? That is, of course, if we can just pretend that we're borrowing at 0%.
Analyst: Did you say underwriter or lead underwriter? I think I can learn to overlook the fallacy of an earnings measure that rewards the debt-heavy, punishes the cash-rich and writes off all buyouts and big-ticket depreciations down to nil.
Maybe it didn't quite go like that. Maybe it went down exactly like that. Either way, while it was mostly smaller upstarts who took advantage of the EBITDA umbrella to introduce pro forma results -- which is basically EBITDA, only personalized with selective bobbing into the accountant's alphabet soup -- I have more faith in the small, focused player than the over-diversified conglomerate.
Or maybe it's just that I have more faith in my own ability to recognize small-cap excellence. Yes, I realize that the common perception out there is that blue chip behemoths are the conservative can't-miss equities. I dissent. I just don't think owning the heavies makes investing any easier. While I have complete confidence in the General Electric (NYSE: GE) executive team, is there anyone out there who feels equally as comfortable and upbeat investing in jet engines, light bulbs, financial services, and broadcast television? If there's a particular subsidiary of GE that draws me in, am I not better hunkering down and finding the pure plays? Why pay up for the combo when all I really wanted was the side of fries? Again, while I trust that GE knows what it's doing, do I know what I would be doing with GE?
You can go for the Big Cheese -- Disney (NYSE: DIS), but if it's the parks that you feel strongly about, maybe Cedar Fair (NYSE: FUN) or Six Flags (NYSE: PKS) is a better way to go. It's the animated library? Why not try Pixar (Nasdaq: PIXR) instead. Each of those three alternatives have market caps between $1 billion and $2 billion. More importantly, they are easier to follow if it's a sector you are familiar with.
Later this month, when we put out our highly anticipated Industry Focus 2002, you will be treated to 18 in-depth takes into promising sectors for the year ahead. Many of the featured companies just happen to be small and mid-cap stocks. Why? Historically, that's where the values lie. Historically, those are the companies that eventually get bought out at a premium. Historically, history repeats.
Then again, you probably knew that already. It's probably why you're here. You've chosen blue highways over blue chips, and the journey has made all the difference.
Welcome to Smallville. Population: You. Me.
Rick Aristotle Munarriz has yet to catch the Smallville television show but he's not afraid of fiscal kryptonite. He does own a few shares of Disney and Pixar. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.