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A Cynical Optimist
An interview with Rick Phillips, Suffolk Capital Management
Rick Phillips is a portfolio manager with Suffolk Capital Management. He oversees a portfolio of US small-cap stocks for Russell.
Russell: How do you go about picking small-cap stocks?
Rick Phillips: Our approach is multi-tiered. We focus primarily on US small-cap stocks with market capitalizations between $200 million and $2 billion — a universe that corresponds roughly with the Russell 2000® Index. We filter this universe through several quantitative screens, which creates a more manageable group comprised of stocks from 16 different sectors. Then we analyze the many facets of each company's current business fundamentals and future prospects. One of the factors we look carefully at is the short- and long-term expectations that various stock analysts have arrived at for individual companies. We give the most weight to the opinions of analysts with the strongest track records. Our goal is to identify undervalued companies with a catalyst (such as a merger or stock buyback) that will lead them to generate positive earnings surprises and analyst revisions.
We're different from a lot of portfolio managers in that we don't put a lot of weight on conversations with company management. In our opinion, the best assessment of a company's management team is their track records, not how well they can promote their company.
Although quantitative analysis is a big part of our strategy, it's not a "black box" process. We try to be as cynical and critical as possible to arrive at a realistic assessment of each company's earnings potential.
Russell: Ironically, though, market sentiment seems to have been more cynical than even you were recently.
Phillips: True, but "cynical" isn't always synonymous with "realistic." In our view, market sentiment was unrealistically cynical through the first quarter. Throughout 2000 and into 2001 a variety of small caps continued to beat analysts' expectations, but people were convinced that those results were going to be short-lived because the economy was slowing. When investors let macroeconomic concerns dictate their decisions, a bottom-up strategy like ours will probably face some temporary disappointments.
More recently, though, our focus on positive earnings surprises and revisions has paid off. In April and May, investors began to shift out of really defensive stocks as they became more optimistic about the economy. At the same time, the valuations of many stocks had gotten to such attractive levels that investors began to take a second look. There are still quite a few companies out there that are outperforming expectations despite the economic slowdown.
Russell: Such as ...?
Phillips: Believe it or not, a lot of small-cap technology companies are still beating their numbers. A good example is a company called Digital Lightwave. Its primary line of business is testing and monitoring fiber-optic networks — a fairly mundane segment of an otherwise high-tech industry.
Until the fall of 2000, investors remained pretty enthusiastic about fiber-optic companies like Digital Lightwave well after they had lost faith in other kinds of telecommunications and technology companies. That changed abruptly in the third quarter. Investors began to worry that the Internet infrastructure buildout was over and bailed out of the fiber-optic stocks that had benefited so much from the trend. Digital Lightwave's shares dropped from a high of $125 in July 2000 to a low of less than $13 in early April 2001.
What most investors failed to recognize is that the so-called end of the Internet buildout marked the beginning of the heaviest demand for Digital Lightwave's services. Once fiber-optic networks are built, they need to be tested, and that's where Digital Lightwave comes in. On a fundamental basis, Digital Lightwave has beat expectations for 10 straight quarters and our analysis convinced us that it had a lot of potential. We bought the stock, which rebounded in April and May. As of mid-May, it was trading above $40.
I think the lesson is that cynicism and optimism can co-exist peacefully in a successful investment strategy. The key is to know when one or the other is truly warranted. It's often when market sentiment heads so decisively in one direction that the rewards of taking an independent view are greatest.
Date of first use: 06/20/01.
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