Jim Collins: Small-Cap Favorites

02/28/2003 12:00 am EST


Jim Collins

Chairman and CEO, Insight Capital Research & Management, Inc.

Jim Collins, who has followed the financial markets since 1950, is primarily a money manager for institutions, individuals, and foundations. In addition, he publishes two top-performing newsletters, OTC Insight and Listed Insight . Here he provides an overview of what you can expect in the small- and mid-cap sectors in the year ahead, as well as an exciting list of favorite stocks.

"I'm a great believer in looking at everything that is traded; we do that with a computer and a database that goes back to 1967. We have a three-step buy process. The first step we call quantitative analysis. We're looking for stocks that have a pattern of outperforming a benchmark. The more a stock outperforms its benchmark, and the lower the volatility, the more we like the stock. We rank some 6,700 stocks on these two characteristics looking for top-performing stocks with moderate risk characteristics.

"We look for stocks with a rising trend; we try to avoid those with huge swings up and down in its price. We start with 6,700 companies and then focus on the top 500. Our second step is then to apply fundamental analysis to those 500. The purpose of fundamental analysis is to determine the true earnings of the company, it true earnings growth rate, and how sustainable those earnings are. Some of the things I like to look at are companies where sales and earnings are both growing. And I like that growth to be at least three times nominal GDP. The real long-term growth rate of this economy is about 3.2% and inflation runs about 2%. Put those two numbers together and you get 5.2% in nominal terms. I like to see companies growing their earnings at three times that rate, or somewhere around 15% to 16%. You can find these firms. In fact in our mid-cap growth portfolio, we're looking at earnings rising 51% on average.

"Another characteristic I like to look at is a high return on equity. It's a measure of how well management is running the company. It simply means if the company earns one dollar and keeps it in the business, how much will that dollar generate? When doing fundamental analysis, you also want to check out a company's competitors. We like a company to be number one or two in its market niche. Often times when looking at small- and mid-cap companies, they are not difficult to analyze. They are often dedicated to some specific niche and are filling that need better than anyone else. If you stick with the top companies in fast-growing niche markets, you'll likely see good long-term returns. We also check out management. Overall, our approach is to find good sectors and then find the best companies in those areas.

"After our fundamental analysis, we are down to a list of about 120 stocks. But I have found that just investing in good companies does not guarantee that you will make money. So you need an edge in the market. How do you get that edge? I had tried everything under the sun, and then about ten years into my career, I hit upon something accidentally. I found that if I invest in a stock that had been in a strong uptrend for the previous six months, which was also outperforming the market, chances were that trend was going to continue for some time into the future. So once we've narrowed our list, we look at how those stocks have been performing in the market. Today, investors use the terms relative strength, and we like stocks that show relative strength of 90 or more, which means the stock has outperformed 90 out of every 100 stocks. This leaves us with about 65 top performing stocks that also happen to be good growth companies. Those become the companies we will consider for our portfolios. On the sell side, we sell a stock mostly because it breaks down on performance. We buy a stock because we expect it to continue to outperform. If it breaks down, we go ahead and sell. A good indication for a stock breaking is taking a ten-day moving average of the stock price and comparing it to the 50-day moving average. When the ten-day goes down below the 50-day moving average, it is beginning to set up a downtrend.

"As for the overall market, there are just no buyers out there. What we see today is a lot of churning by hedge funds with billions of dollars. Institutional investors have no place to put money. Bonds don't provide any yields and they don't want to allocate more money to stocks. They are just letting cash build up. Our own work shows over $2.5 trillion sitting in institutions on the sidelines. And we've seen estimates as high as $7 trillion sitting in money market assets. But it's the institutions that determine the direction of the stock market. But if you only have hedge funds churning and institutions sitting on the sidelines, you get exactly the kind of market we are now seeing. Looking ahead, we think that growth stocks will outperform value stocks for the next couple of years. They go back and forth. Value has been a great place to be for the last few years. But I think growth will come back into its element here and going into 2005. What happened coming out of the recession of 1973-74? Large-cap stocks in 1975 were up 37.2% and in 1976 they were up 23.8%. But small-cap stocks were up almost 53% in 1975, followed by a 57% rise in 1975. The overall return on large caps from 1975 through 1980 was 163%. Small-cap stocks, however, rose 647%. That's a big difference.

"People who have made a lot of money shorting stocks may be in for a big surprise once we get the Iraq issue off the table. When the NASDAQ spiked up above 5000, we were nearly five standard deviations above the market's long-term trendline. Now, at 1300 we are about three standard deviations below that trendline. To get back up to 1700 is about a 30% move and that would still leave us well below the trendline. This won't happen overnight, but I do think the NASDAQ does have at least 30% upside over the four quarters following the Iraq problem.

"So what sectors of the market offer the best growth opportunities? There are four areas that have allowed us to make more money than any other place in the market, particularly in periods after the Fed goes through rate decreases: information technology, consumer discretion, healthcare, and financial. We're currently having some trouble finding good growth companies in the financial sector, but we are now weighted very heavily in the other three categories. Overall we're in an unusual time where the upside potential is far greater than the downside. There is some sunshine beyond the clouds. Just be a little patient. Meanwhile, here are my top stock picks:

"FTI Consulting (FCN NYSE) is a company involved in corporate restructuring. It's doing very well and has a long-term growth rate of 20%. We're looking for $2.16 this year and $2.64 next year. That would be 35% growth this year and 22% next year. SLM Corp. (SLM NYSE) is the leading company in student loans and it is capturing market share. We're looking for earnings of about $5.39 a share this year, up about 17%, and $6.22 next year, up 15%. The long-term growth rate is about 15%. Engineered Support Systems (EASI NASDAQ) designs and manufactures military support systems. The company seems to have very good earnings going forward. And it's a reasonably priced defensive play, with a long-term growth rate of about 17%. They should earn about $1.92 this year and $2.09 next year.

"Netscreen Technologies (NSCN NASDAQ) and Symantec (SYMC NASDAQ) are two of my favorite stocks. We have to be careful analyzing Netscreen because they didn't pay any taxes in recent years and most likely won't pay taxes this year. We're looking at $0.56 this year and $0.58 in 2004, but then $0.89 in 2005. This company is a leader in the high-end of providing firewalls and virtual networks and intrusion detection systems. Symantec is also an Internet security and administrative software firm. We're looking for earnings to be up 51% this year to $1.31. Next year, we see $1.81, a 38% growth rate. The long-term growth rate is about 40%. On Netscreen, were looking at a long-term growth rate of 35%.

"Varian Medical Systems (VAR NYSE) is the largest provider of oncology medical systems. We're looking at about 26% growth this year, with earnings of $1.68. Next year, we see $1.97, up 17%. Cray (CRAY NASDAQ) is known for supercomputers. The company remains the leader in this market; it's just getting ready to ramp up the new X-1 supercomputer. We're looking for earnings to be up about 71% this year to $0.24 and up 38% next year to $0.33. This stock has a long-term growth rate of about 20%-25%.

"The two Internet companies that we really like are Yahoo! (YHOO NASDAQ) - the world's largest Internet destination - whose earnings will be up 61% this year to $0.29. Next year, we'll see a 26% increase to $0.41.The long-term growth rate is about 26%. E-Bay (EBAY NASDAQ) is the largest online marketplace. This company has 55 million registered users. It did $3.8 billion in transactions last year. It's a little bit pricey. In this kind of market you don't have to chase these kinds of stocks. But if you can buy E-Bay at 70-71, I'd put it in a portfolio and hold on to it for quite a while.

"We do like some other Web-related stocks. We're positive on Amazon (AMZN NASDAQ), and if you think travel will ever come back, consider Expedia (EXPE NASDAQ) and Hotels.com (ROOM NASDAQ). A couple of other names we like are Qualcomm (QCOM NASDAQ), which is coming out with some advanced features on cell phones. We also like Cree (CREE NASDAQ), a semiconductor company. Retailers that we like include Chico's FAS (CHS NYSE) and Coach (COH NYSE). Finally, in the educational area, we've made a lot of money on Apollo Group (APOL NASDAQ) and Corinthian Colleges (COCO NASDAQ) and they remain our top choices  in this sector."


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