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Spotlight on: Small-Cap Investing
Targeting Value Stocks in the Small-Cap Arena
March 22, 2001
If you're looking for value stocks, you might try looking in a place you might not have expected to find them — small-company technology stocks. So says Erik Ogard, Russell Small Cap Portfolio Manager, who believes some small-cap stocks offer exceptional value. The reasons: Pricing inefficiencies occur more often in small-cap than in large-cap stocks. And many small-cap stocks are valued at lower levels than their large-cap counterparts.
Most people think of small-cap stocks as growth stocks only. But, Ogard points out, Russell takes a more balanced view, recognizing that small-cap companies come in all styles and exist in all economic sectors. Choosing the best value small-cap stocks to buy poses risks as well as potential rewards. You should not buy small-cap stocks simply because their valuations are low. Such valuations might suggest a company is facing serious operating challenges. Nor should you buy them just because they are cheap.
To find value stocks, you need to know how to evaluate what a business really is worth.
 "You have to do your homework," says Ogard. "For example, a company may have a division that's about to dominate the marketplace. You have to ask yourself, 'If I were a business person, would I buy this company for a particular piece of its business?'
"Investors can read a balance sheet to determine a company's current value," Ogard says, "but they may not be able to identify a company's real potential." Differentiating small-cap stocks that are deservedly cheap from those that offer compelling opportunities is a potentially rewarding investment approach. Yet few investment professionals — let alone individual investors — have a track record of discovering these kinds of opportunities.
Ogard cites Ben Nahum of David J. Green & Co., New York, a Russell high-ranked US small-cap equity fund manager, as one who has such a track record. Russell's Investment Management Group (IMG) monitored Nahum's performance for several years as he bought deeply discounted stocks of companies in economically sensitive sectors, such as technology, and secured impressive rates of return.
Today, Nahum is one of a number of investment managers tapped by Russell to manage a portion of its assets that are directed to the small-cap value segment of the market within Russell US equity funds.
The "contrarian" philosophy
While investors tend to follow the markets, Nahum advocates going against the grain. "In periods of transition," Nahum says, "share price movements tend to be exaggerated. The contrarian focuses on sectors in which stock prices have dropped, identifies specific companies with sound valuation characteristics and makes a long-term commitment."
Nahum backs his philosophy with action. In January 2001, about 24% of his portfolio consisted of technology stocks, a position few investors would have the heart to take given the Nasdaq correction of the past year.
Assessing value in a challenging climate
Three technical factors determine attractive valuation, according to Nahum — low price-to-book, cash flow and earnings. Investors must do more, however, to identify true value opportunities.
Nahum pays close attention to mergers and acquisitions because they reveal what knowledgeable business leaders are paying for similar values. He draws the analogy of a real estate broker comparing home sales in a neighborhood to determine a particular house's worth in the marketplace.
Nahum also places multi-divisional companies under the microscope. "You have to take these companies apart," Nahum says, "and ask, 'What is each piece of the company worth as a stand-alone business?' " Divisions must be compared to single-industry companies performing the same functions and currently being publicly traded.
Putting high P/E ratios into perspective
It's no surprise that Nahum prefers the lowest possible price/earnings (P/E) ratio to determine value. But there are occasions when investors should be prepared to pay higher multiples in exchange for long-term opportunities.
For example, according to Nahum, "If cable operators are generally willing to pay 15 times cash flow for a cable property, and a cable property can be found at 10 times, that may be very attractive, even though the P/E is high."
Such a company may be able to increase returns through better yields on capital spending. A company with two components may sell a weak one, then reinvest its new capital in more profitable areas related to its high-performing component, thus increasing its intrinsic value.
Focus and commoditization
Diversification adds value to a mutual fund, Nahum maintains, but not to most companies. "The market doesn't like a business investing in many other businesses that don't do well. The market can diversify for itself and prefers that a company focus on what it does best."
Macroeconomic factors also require investor attention. The best corporate strategies can be rendered ineffective in a slow economy that inhibits growth. Moreover, a company's value can plunge when its products or services become commoditized — easily copied with no unique differential — unless markets grow rapidly, creating a rising tide that lifts all competitors.
A sense of long-term opportunity
Numbers, Nahum points out, represent only a starting point for investors who must be intimately aware of a company's management — a task usually undertaken only by professionals. "A company's competitiveness and strategic attempts to create shareholder value must be identified," he says.
In this regard, portfolio managers can hold a clear advantage over individual investors. Nahum spends most of his time traveling and getting to know top executives. Investors can not gain anything comparable in the way of access to the executive suite and the insights it offers.
Ultimately, however, Nahum does not rely on an algorithmic formula for success to find exceptional value in small-cap sectors. After running the numbers, he relies on his inner sense of where opportunities lie. This approach requires both experience and patience in the face of short-term earnings and share price worries.
Nahum's strategy, according to Ogard, fits well into Russell's MULTI ASSET MULTI STYLE MULTI MANAGER™ philosophy. "David J. Greene & Company is one proven investment manager among many at Russell," Ogard concludes. "Their value approach represents only about 5 to 7% of our small-cap portfolio. It is important, however, because it provides Russell investors with real diversity for positive long-term performance."
For further information about these contents, please contact Russell Investments Canada Limited.
Copyright© Russell Investments Canada Limited 2001. All rights reserved. Date of first use: 03/22/01.
Small-cap companies in the technology sector are heralded for growth, not value. Getting beyond accepted definitions and understanding what makes a company tick can uncover attractive opportunities for informed risk takers.
This is a publication of Russell Investments Canada Limited. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have.
Small company issues can be subject to considerable price fluctuations
The opinions expressed by the professionals featured in the above article are not necessarily those held by Frank Russell Company, its affiliates, subsidiaries, or distribution channels. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
Russell conducts a rigorous manager research process and provides a select set of top-rated investment managers for clients, such as the professional featured in the above article. Russell continually evaluates and re-evaluates investment managers to ensure that our clients receive comprehensive and strategic diversification. We believe that diversification through multiple asset classes, multiple styles, and multiple managers will enhance long-term performance while managing risk.
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