Small Caps from Top Managers

03/12/2004 12:00 am EST

Focus:

Don Phillips

Managing Director, Morningstar, Inc.

Over the past two decades, Don Phillips has built Morningstar into one of the nation's leading advisory firms, for both mutual fund coverage and stock research. Here, his analysts highlight some of the favorite stocks from small cap fund managers.

"Small-cap growth investing isn't for the meek. After all, betting on small-cap stocks can be risky regardless of valuation. Small-cap companies on both ends of the growth/value spectrum are often reliant on a limited number of products and business lines for their survival and may not have the financial wherewithal to weather tough environments. But investing in small-growth firms courts added volatility by emphasizing faster-growing and higher-priced companies—the type whose shares can tumble in a hurry when their businesses suffer a setback. While it's clear small-cap bargains may be increasingly scarce, some fund skippers still say there are underappreciated gems to be had. We thought we'd highlight some picks that have emerged in recent conversations with Morningstar analysts.

""Ron Baron, founder and manager of Baron Growth (BGRFX) doesn’t chase fads. Instead, he favors companies with relatively predictable growth rates over the next three to five years. Tech and biotech stocks rarely are stable enough to make the grade. Baron is particularly fond of companies trading cheaply relative to their cash flows. Thus, he generally gravitates to steadier growers in service industries. One such example is 99 Cents Only Stores (NDN NYSE). The discount retailer's shares slumped in 2003's fourth quarter on concern over the slowness of its rollout in Texas. However, Baron thought the setback was temporary, and viewed it as a chance to double the fund's stake in the company.

"Irene Hoover, manager of namesake Forward Hoover Small Cap Equity (FFSCX), is a small-growth manager with a sensitive side. Hoover fills her portfolio with growth stocks, but she requires her picks' trailing p/e ratio to be less than two thirds of her estimate of the firm's earnings-growth rate. That means her fund is usually light on tech fare, which usually is too expensive to meet her criteria. Instead, Hoover favors names like retail furniture maker Furniture Brands International (FBN NYSE), which she scooped up recently. She says the company is reasonably priced and generates a lot of free cash flow. She likes the retailer's new strategy, which includes outsourcing manufacturing to China to reduce costs, and she believes the company may soon pay a dividend. Hoover is also a fan of Patterson-UTI Energy (PTEN NASDAQ), which provides onshore drilling services. She argues the company will benefit from increased drilling for natural gas in the United States.

"Like Hoover, Wasatch Core Growth (WGROX) manager J.B. Taylor looks for fast growers trading at reasonable prices. Taylor looks for firms that will deliver consistent earnings-growth rates of between 15% and 25% over a three- to five-year time horizon. He also demands that a potential holding's trailing p/e ratio be less than or equal to the firm's projection of its own sustainable earnings-growth rate. Recent purchases include Fidelity National (FNF NYSE), one of the leading title insurers in the US. Taylor says the company is moving to a more attractive transaction-oriented business model, but its valuation doesn't yet reflect this reality. Another favorite is regional bank Commerce Bancorp (CBH NYSE). Taylor says the firm is gathering deposits at a brisk pace, which should fuel strong earnings growth. He also points out that its consumer focus gives it an edge over more-diversified banks.

"Overall, Eric Ende, manager FPA Perennial (FPPFX) and FPA Paramount (FPRAX), isn't enthusiastic about stocks. However, Ende says a few healthcare names have caught his eye. Most notable is Health Management Associates (HMA NYSE), a recent addition to both funds. Ende argues the rural hospital operator has a history of generating high returns on capital and produces better profit margins than its rivals in the industry. He also added to his stake in Lincare Holdings (LNCR NASDAQ), which provides oxygen and other healthcare products to patients' homes. The stock slide stems from a provision in the new Medicare prescription drug bill that slashed government reimbursements to oxygen providers like Lincare. Ende concedes the move will hurt Lincare's earnings, but not by as much as investors expect. He also believes the company is the strongest in its industry and can weather the downturn better than its competitors.

"Like famed value investor and Third Avenue founder Marty Whitman, manager Curtis Jensen of Third Avenue Small Cap Value (TASCX) is a cheapskate. Indeed, he looks for companies with strong balance sheets selling for less than half what he thinks they're worth. Jensen likes JAKKS Pacific (JAKK NASDAQ), which markets toys, collectibles, and other kids' products. He likes the company for its ability to generate free cash flow and double-digit returns on capital. He also says the company is cheap, trading at modest multiples of cash flow, earnings, and book value. Jensen has also added to the fund's stake in St. Joe (JOE NYSE), the largest private landowner in Florida. He argues its skilled management has ably built upon the value of its impossible-to-reproduce assets and thinks it will continue to do so in the future."

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