The Rule Breaker Portfolio, Small Company Stocks, October 24, 1996

INTRODUCTION

The investment community has the average investor agog over "small-cap" stocks. If the preponderance of mutual funds alleging to purchase just these puppies is any yardstick, buying small-cap stocks for big-time growth is one of the more prevalent pearls of financial wisdom out there. Many individual investors just taking control of their savings on a quest to build wealth often become completely preoccupied with the idea. In order to capture the next Microsoft or Intel before it happens, they buy small-cap names, loading up their portfolio with all sorts of obscure stocks selling for less than a dollar on Canadian exchanges. These investors, unfortunately, are normally sorely disappointed and end up putting their money right back into the underperforming mutual funds they removed the money from out of frustration.

Despite the fact that everyone is talking about small-cap stocks, very few people actually add anything resembling information to the discussion. The financial community remains content that its marketing job of getting investors to buy small-cap mutual funds has been done, but all kinds of questions floating around are left unanswered. What is a small cap or a small-company stock? What is the difference between the two? When does it make sense for an individual investor to consider buying such a vehicle? How does an investor look for good small-company stocks? What kind of broad characteristics should an investor look for in order to reduce the extreme risk attendant with purchasing little-known names which frequently have short histories as publicly-traded entities? All these questions and more will be addressed here in Small Company Stocks.

Part 1 of 3
SMALL CAPITALIZATION OR SMALL COMPANY?

Does the size of the market capitalization correlate well with the size of the company? The way people talk about small-cap investing, you would think that it would. However, it does not. In order to to begin to answer this question, first we have to define what capitalization is. Capitalization, short for market capitalization, refers to the current dollar value of all of the outstanding shares. Thus, if a company has 100 million shares outstanding and is currently priced at $20 a share, it has a market capitalization of $2 billion. (See Example below.) You can find a much more detailed discussion of market capitalization in the article called Revenue-Based Valuations in the Fool's How to Value Stocks area.

EXAMPLE:

Shares Outstanding * Current Price = Market Capitalization

100 million * $20 = $2,000 million = $2 billion

Small-capitalization stocks are companies whose current market capitalization is small relative to other companies that trade publicly. An alternative way to measure the size of the company is to look at the revenues it has generated over the last year. A company that has generated less than $10 million dollars in sales over the past twelve months is definitely small. How small is small for small-capitalization or small-company stocks? Although there is no set definition used in the financial world, you will find that most people use the following definitions, which come straight out of the Motley Fool Investment Guide and the Eighth Step to Investing Foolishly (Consider small-cap growth stocks).

Large-cap/company: Over $1.5 billion

Mid-cap/company: $200 million to $1.5 billion

Small-cap/company: $50 million to $200 million

Micro-cap/company: Less than $50 million

Although these are good ground rules, it is important to realize that the overall capitalization of all stocks on the market is growing by a decent amount on an annual basis, meaning that what is small capitalization now might not be small capitalization in the future. Some (like myself), might argue that Tom and David's definition of the various sizes is skewed a little low and you might be better off for investment purposes looking at it like this:

Large-cap/company: Over $5.0 billion

Mid-cap/company: $500 million to $5.0 billion

Small-cap/company: $100 million to $500 mil. (ATCT will fit here in ' 97)

Micro-cap/company: Below $100 million

Why use one approach in looking for small companies over another? Unlike trailing revenues, market capitalization is greatly affected by how popular a company currently is. Despite the fact that YAHOO!(NASDAQ: YHOO) has generated $6.37 million in revenues over the past four quarters, obviously qualifying as a small company, the Internet search engine currently has 27.07 million shares outstanding at a price of $21 1/4 per share, giving it a market capitalization of $575 million, making it a mid-cap stock. Yahoo! is a great example of how not all small capitalization stocks are small companies and not all small companies are small capitalization stocks.

In the end, it all depends on what you are looking for. When you are looking for a small "growth" stock, don't look for small capitalization stocks -- look for small company stocks. Capitalization is an arbitrary measure of company size -- look at revenues and view capitalization as a valuation measure, not an objective measure of scale. This is not to say that there are times when you might want to look for small-cap stocks. Looking for medium and large companies priced with small capitalizations is a superior strategy for value investors, but it is a discipline separate from finding small "growth" companies. For our purposes in this series, we are "drilling down" to discover how to find small growth companies. We'll leave a discussion of how to find medium and large companies priced at fire-sale rates for another day.

Part 2 of 3
THE RISKS AND REWARDS OF SMALL COMPANIES

I. The Odds Are Against You

Small company stocks are often held out as the Holy Grail of investing. Using rich analogies to seeds and acorns, investment prospecti love to imply that by simply putting money in tiny companies, your savings will one day become as mighty as an oak. Although there are a lot of excellent reasons to consider investing in small companies, the emerging statistical reality is that they may carry more risk for returns comparable to what you can get in larger, more liquid companies. This emerging body of thought is founded on consistent underestimation of the odds of a long shot and the "extinction" effect in the databases used to construct average historical returns for classes of stocks.

Common sense tells you that if you consistently bet on a 40-to-1 horse, you should win one out of every forty times, right? Theoretically, the odds given (3-to-2, 2-to-1 or whatever) are odds that are set by the market and should include no inherent advantage. However, rigorous statistical analysis of parimutuel betting by a number of scientific sources has found that people routinely underestimate the odds for the favorite and overestimate the odds for the dark horse. This means that the 40-to-1 horse actually ends up winning more like one out of every 45 times and the 2-to-1 favorite actually wins more like three out of every five times. So, if you go to the racetrack and consistently bet on the horse that has the best odds, over time you are likely to have a substantially better return than if you were to consistently bet on the horse with the worst odds.

The hypothesis that explains why the free market of odds-setting for parimutuel betting is inherently inefficient is called the "swinging for the fences" phenomenon. In baseball, if you are constantly swinging as hard as you can to try to hit a home run, your batting average plunges. The same is true of bettors who pony up their stake for the long shot, dreaming of the lottery-like riches that will come streaming back to them if they win. On a mass scale, this human tendency actually moves the odds so that long shots actually appear more likely to win than they will, in reality, win. Imagining how this effect can exist in the public markets is not all that hard and goes a long way to explaining why companies like COMPARATOR SYSTEMS (NASDAQ: IDID) CURTIS MATHES (NASDAQ: CRTS), and IMATRON(NASDAQ: IMAT) can suddenly surge in spite of the underlying fundamentals of the business. People hear the story, assume that the low stock price means it is "cheap," and then swing for the fences... often with disastrous results. The simple reality is that the odds are slightly against you in small company stocks.

II. The "Extinction" Effect

How can one reconcile the fact that the odds are actually against you when investing in small company stocks with the fact that as an asset class, small-capitalization stocks outperform large capitalization stocks over time? The first reason is because not all small-capitalization stocks are small-company stocks, as we learned yesterday. Small-capitalization stocks as an asset class include many medium and large companies that have been beaten down so much that their capitalizations have become tiny -- making them incredible bargains if they can actually get some leverage and turn their businesses around. Thus, when you see small-cap funds that say they invest in small companies but discuss the long-term benefits of investing in small-cap stocks, you now know that they are mixing up two different things in their arguments.

The second reason why small company stocks might actually have worse "odds" than medium and large companies is the simple fact that all of the historical data on small-company returns (separate from small-capitalization returns) has been biased by an effect statisticians call "extinction." Unfortunately, as many with a science background realize, most investment professionals are not scientists. When you see historical statistical returns on small companies versus large companies, this all comes from databases that have been marred by the routine removal of information about bankrupt companies.

Thus, when a company becomes "extinct," the fact that its effective return was negative 100% is not factored into the returns that you see. In most of the public data, small-company stocks return in the neighborhood of 13% per annum and S&P 500-type stocks return around 10% per annum. Some statisticians have argued that the entire 3% outperformance can be explained by the exclusion of this data. Thus, the fact that small companies disproportionately go bankrupt and disappear pumps up the compounded annual returns of their asset class. The suggestion that small company stocks might not actually outperform their large company brethren as a group could actually be accurate, given that the average annual bankruptcy rate of about 1% is weighted much more toward smaller enterprises.

III. Controlling Risk in Small Companies

A lot of the extra risk inherent in small companies as a group can be controlled if you just avoid the instances where the odds have been mispriced because the companies are such huge long shots. To achieve this as an investor, you must stop "swinging for the fences." If it is flashy, catchy and promises a hundred-fold reward, the odds of it succeeding have probably been shifted by hundreds of small investors hurling themselves at the stock like lemmings. This is the racetrack equivalent of betting on the horse with the "cool" name. As any child who has ever been to the racetrack can tell you, this is not the best way to make money. The two main "swinging for the fences" kinds of companies I will highlight are "development-stage" technology firms and small companies attempting to bust into huge markets already dominated by world-class firms.

What makes a small company "flashy" and a candidate for the "swing for the fences" folder? "Radical" new technologies, often promoted by the companies themselves or by small brokerage firms tied closely to the firms as underwriters or market makers. If it sounds like science fiction, odds are you are investing in something that will lose you a lot of money. People talk all the time about finding the next Microsoft or Intel, neglecting the fact that both companies were medium-sized firms already established in their industries when they came public. These supposed development-stage technology firms only come public early on when they cannot find a venture capitalist dumb enough to pump some dough into the firm. Given that venture capitalists have funded some pretty dumb deals, this really leaves the individual investor with dregs that are almost guaranteed to absolutely fail. Of course, there are exceptions to this, as with any rule, but as always, this does not make the rule invalid.

Small companies that are gunning for big markets dominated by large companies are also often the worst kind of investment. The odds of a small company breaking into the diaper market, the soup market, the operating system market, the applications market or even more contentious and lower-margin businesses, like personal computers or televisions, is always low. There are big companies entrenched there with an ample supply of capital to cut you off at the knees before you even get started. Occasionally you do see a small upstart come out of nowhere and redefine an entire industry. More often, though, you see a small upstart find a niche that is growing like a weed and use success in this niche to leverage its entry into the larger market, a la FORE SYSTEMS (NASDAQ: FORE) buying ALANTEC(NASDAQ: ALTC) to get into LAN switching from ATM switching. ATM switching was a niche market that FORE was very good at, and it used these profits to enter the larger market and become a player.

PART 3 of 3

I. MISPRICED BECAUSE OF LIQUIDITY

Some will perceive my two-pronged argument that small-company stocks are on average riskier and overall do not outperform large-company stocks as a total indictment of small-company investing. This is not at all the case. Rather, it is an indictment of the ill-conceived blanket statements that the financial industry and the financial press like to make about investing in small companies as a guaranteed way to grow your savings into a mighty oak. Statistically, there are no grounds to say this -- or to say, conversely, that it is actually a way to diminish your savings into insignificance. To make a case for investing in small-company stocks as a class, you must understand why some companies within that class can get mispriced or have the wrong odds placed on them, consequently opening up the opportunity for above-market returns.

What is the upside in small companies? Small companies are more volatile and more inefficiently priced because of something called "liquidity." Liquidity is an investment term that is used to describe the ease with which a given investment can be converted to cash. Different investments have varying degrees of liquidity attributed to them. The high-ticket price and great shifts in demand in the real estate market make real estate a fairly illiquid investment. Contrast this with cash in your bank account -- the most liquid form of savings possible, as it would take only a deposit slip to convert it into cash in your hot little hands. The main factors that drive liquidity include the asset class, the size of the market for that asset class, supply-and-demand dynamics of that asset class, and its utility to the owners. Stocks are considered a pretty liquid type of investment as there is a huge market of daily buyers and you know the going market price at any given time. Within that market, however, some types of stocks are more liquid than others.

The reason why small-company stocks can be mispriced by the market and promise huge returns is because they are normally less liquid than their medium- and larger-company brethren. Massive institutions and pension funds simply cannot buy a reasonable amount of the stock of most small companies to make a difference in their overall return. This happens partially because of the SEC's disclosure cap, which requires that any entity that owns more than 5% of a company be forced to report their holdings and changes in those holdings to the public in a timely fashion. Also, many companies have internal caps on the amount of one firm they can own as well. An example is FMR Inc., Fidelity's parent company, which can only own 12% of a company in all of its funds together. When you own a large slug of a company's stock, it becomes difficult to sell out of it without affecting the price. If major bad news happens, it might in fact become impossible to find enough buyers for the stock, leaving the investment firm stuck with the whole amount. This is why medium- and large-cap stocks are more liquid. Although some small-company stocks become medium- and large-capitalization stocks because the market prizes them so, more often than not small-company stocks are also small-cap stocks -- meaning that the big money cannot own them and their stock is potentially mispriced.

II. WHY INVEST IN A SMALL-COMPANY STOCK?

Because small-company stocks are eschewed by investment firms, pension funds and mutual funds, as well as by the large community of analysts that live off of the fees and services of such funds, they can be really mispriced by the market. In spite of the fact that these small companies can be turning out superior growth and earnings results, their valuations can stay very low because for some reason the stock has not attracted the attention of Wall Street. The optimal scenario for success in investing in a small company is to find one on the verge of becoming a medium or large company in a reasonable period of time and to get in early, before everyone else notices.

A small company sees its valuation driven by becoming a big company. A benchmark that I use a lot when evaluating small companies is to ask how long it will take at the current revenue growth rate to hit at least half a billion dollars in sales, the verge of medium company-dom. By using such a guideline, you focus on companies that are growing sales at a rate to hit at least $500 million within the time period you anticipate making money, normally three to ten years for the Foolish small-company investor. Sure, doubles within six months are great, but as always, you want to avoid swinging for the fences and taking on too much risk. Simply planning on smashing the average 10% return on the S&P 500 is normally more than sufficient.

The reason why I focus on revenues is that while price/earnings ratios have a tendency to fluctuate quite a bit, price/sales ratios tend to be less volatile and a little easier to make conservative predictions about. If a small company is growing at a decent rate and is fast heading toward becoming a medium company, a price/sales ratio of 1.0 is not an unreasonable expectation. This means that at $500 million in sales, you will see a company with a $500 million market capitalization and you will see analysts initiating coverage, investment rags talking the stock up, and funds buying like it is going out of style. And you will have happily been holding on since the sales were $100 million or $200 million, meaning that you may have made as much as five times your money in three to ten years -- not bad.

Here are the average annual sales growth rates needed to grow to $500 million in revenues from various starting points over various periods:

    Three Years Five Years Ten Years

    $50 million 113.7% 58.4% 26.9%
    $100 million 70.1% 40.0% 17.5%
    $150 million 48.8% 27.2% 12.8%
    $200 million 35.3% 20.1% 9.6%
    $250 million 25.7% 14.9% 7.2%

You read it like this:

___ million in sales grows to $500 million in sales in ___ years at an average annual growth rate of ___ .

So, the $50 million, three years, 113.7% looks like:

$50 million in sales grows to $500 million in sales in three years at an average annual growth rate of 113.7%.

Because the rate of growth in sales, earnings and market value tend to converge over time, people who can find solid, truly mispriced small companies early on are rewarded for their persistence and patience over long periods of time. Statistically speaking, you will take on more risk with a small operation, as a fast-growing firm runs into quite a few problems, but this risk can be mollified by simply owning six to ten names. In batches of this size, you will find that you have one or two disasters, one or two huge winners and the remainder simply tread water.

III. WHERE DO YOU FIND SMALL COMPANIES?

The best place to find small companies remains the Peter Lynch way -- look around your daily life and you will inevitably notice something before the rest of Wall Street does. Many people take this as an admonition to "buy what they like," but it is nothing like that at all. Rather, it means that you as a consumer are much more attuned to new and fast-growing phenomena than the average portfolio manager who is poring over 10-Ks and 10-Qs eighteen hours a day. You tend to find things long before Wall Street discovers the fad and starts having eighteen initial public offerings a day with companies currently in the hot sector. You also tend to find things that might currently lack sex appeal, but which, with continued strong growth, could some day demand the investment attention that they deserve.

Another great thinker on the small-company front is Ken Fisher, who articulated the "small companies, small markets, big companies, big markets" premise in 1984's Super Stocks. This essentially means that small and fast-growing markets are the best places to find small and fast-growing companies that can sustain their growth. Rather than looking for the small company attacking the big market, as discussed in "Controlling Risk in Small Companies," you want to find the small company out in front in the fast-growing market. Many people ignore these companies because of the conventional wisdom that some big company will come in and take over. Despite the fact that big companies succeed more than the odds would suggest, the threat of some big company entering into a new market and crushing a small company is always overrated. Folger's did not stop Starbucks. Kentucky Fried Chicken did not stop Boston Market. Cisco did not stop FORE Systems. IBM did not stop Microsoft. And so on. In fact, small companies in small markets need to worry about smaller companies surpassing them, not bigger companies squashing them.

In the end, it is best to offer examples of the small companies I am talking about. Recently, Market Guide gave someone here at Fool HQ their screening software and I took the opportunity to run through it for small companies growing fast enough to become big companies within a few years. In order to find companies that will reach $500 million in sales in three years, I looked at my chart for companies with between $125 million and $175 million in revenues and with compound annual sales growth rates over the past three years of 50% or more. Out of the 68 names that popped out, I present a list of random highlights that should serve as good examples of the kinds of small companies I am talking about.

ACT MANUFACTURING (NASDAQ: ACTM)
APAC TELESERVICES (NASDAQ: APAC)
CAMBRIDGE TECHNOLOGY PARTNERS (NASDAQ: CATP)
CASINO MAGIC CORP. (NASDAQ: CMAG)
CIBER INC. (NASDAQ: CIBR)
COMVERSE TECHNOLOGY (NASDAQ: CMVT)
DATA SYSTEMS & SOFTWARE (NASDAQ: DSSI)
DREW INDUSTRIES (AMEX: DW)
EAGLE USA AIRFREIGHT (NASDAQ: EUSA)
HCC INSURANCE (NYSE: HCC)
HORIZON GROUP (NYSE: HGI)
INSIGNIA FINANCIAL GROUP (NYSE: IFS)
LANDRY'SSEAFOOD (NASDAQ: LDRY)
MCAFEE SOFTWARE (NASDAQ: MCAF)
NUMBER NINE VISUAL TECHNOLOGY (NASDAQ: NINE)
RISCORP (NASDAQ: RISC)
STB SYSTEMS (NASDAQ: STBI)
STRATEGIC DISTRIBUTION (NASDAQ: STRD)
THOMPSON PBE (NASDAQ: THOM)
VETERNARY CENTERS OF AMERICA (NASDAQ: VCAI)
WELLSFORD RESIDENTIAL (NYSE: WRP)