The Best Medical Small Caps

08/15/2003 12:00 am EST

Focus:

James Oberweis

President, Oberweis Asset Management, Inc.

Jim Oberweis,  money manager and editor of The Oberweis Report, focuses on aggressive growth at a reasonable price among small- and micro-cap stocks, using an eight-point system for analyzing stocks. His returns for the first half of the year are in excess of 40%. Here are his favorites in the medical field.

"In the late 1990s we saw a market that very much favored large-cap investments. Times have changed. This year a new cycle started, and it began favoring small-cap growth names. So far this year, small-cap growth is the top performing asset class. This is a time we believe that small growth is likely to continue to outperform. Historically, these cycles are not six months or a year, but are typically four to five years. The small growth sector tends to do best when the economy is coming out of a recession, something that we believe is starting to happen right now.

"We call our system the Octagon. It’s a framework that we use to try and identify the companies that could become tomorrow’s Microsoft or Cisco. We begin by looking at a company’s sales growth under the assumption that those companies that are most successful in increasing sales over the long term are also those that are most successful in the stock market. We look for companies that are generating internally-generated sales growth as opposed to growth acquisitions. The second factor we look at is earnings. We try to buy companies exhibiting commensurately high earnings growth–a minimum of 30% is required. The third part of our quantitative process is called the PEG ratio–or price to earnings growth. We look for a low valuation in relation to a company’s growth rate. We try to acquire companies with p/e multiples no more than one-half of their growth rate. If a company is growing at 40%, we would look to acquire the shares at 20 times earnings. Those three are very objective rules and are present in every single investment we make.

"The others factors are more subjective and are not necessarily present in every stock we own. Our fourth is long-term growth sustainability. We look for companies that have the ability through their products or services to sustain growth for many years to come. Those are typically companies with a patent or a unique technology–something that would allow them to grow and fend off competitors for many years. Sixth, we like to see companies that are accelerating their rate of earnings growth. We like companies that are growing at 30% this year and might grow at 40% or 50% in subsequent years. If we can anticipate a higher growth rate it suggests that people will pay a higher price for those stock in the future. We also like to see companies with low price-to-sales ratios. Seventh, we look at the quality of earnings. We like conservative earnings reports where management is still keeping some money in their pockets for a rainy day. Lastly, we like to see companies with high relative strength–stocks that are outperforming those of its competitors. These eight steps are the foundation of how we look at stocks.

"One of our favorite areas is the medical and healthcare marketplace. In particular, we like companies that can help contain costs and help baby-boomers afford medical care. Caremark Rx (CMX NYSE) is a company that provides pharmaceutical management services. Many people have cards that they show at their pharmacy to get prescription drugs. There are about half a dozen different providers, but we think Caremark is the most attractive of the group and the best managed. The valuation is quite attractive and the company’s prospects going forward are still strong. Also in this area is a smaller company–HealthExtras (HLEX NASDAQ). It’s roughly a tenth of the size of Caremark and it trades at a somewhat lower valuation. The company has a disadvantage in that this is an ‘economy of scale’ business. But the advantage is that they can carve out particular niches and grow those niches at a faster rate.

"The second area that we think is exceptionally attractive is the generic drug manufacturers. In our opinion, the political winds that are moving in favor of the generic drug companies are just beginning. One of our favorites is Able Labs (ABRX NASDAQ), a very small, niche player that focuses on drugs that fall below the radar of big generic drug companies. It looks for drugs with under $100 million in sales. We also like Bradley Pharmaceuticals (BDY NYSE), for those willing to take on legal risk. The company makes a skin anti-irritant that represents about 55% of sales. Last year, the stock dropped significantly when a competitor announced that it would develop a competing version. There are never clear-cut answers in court litigation, but in our estimation, Bradley is likely to win. The experts we’ve talked with believe Bradley’s patents will hold up in court. The outlook is not clear and there is risk. But in exchange you are able to acquire a high growth company trading at an exceptionally low valuation.

"Here are some other favorites: Merge Technologies (MRGE NASDAQ) operates within a niche. They provide a digital database of radiology images. Rather than carrying X-rays around between doctors and hospitals, radiologists can view, access, and store these images digitally. This technology is being rapidly adopted and Merge makes the software that makes this happen. IMPAC Medical Systems (IMPC NASDAQ) makes IT solutions for cancer treatment, so that cancer patients’ needs are met directly. This is again a niche company that sells directly to cancer treatment centers. It was a recent IPO and the numbers have been very strong.

"Biolase Technology (BLTI NASDAQ) makes dental products, primarily lasers and water jet technology for teeth cleaning and teeth whitening. We also like Candela Laser (CLZR NASDAQ), which is used among other things to remove varicose veins. Also in the same market, we like Palomar Technology (PMTI NASDAQ). We also like Psychiatric Solutions (PSYS NASDAQ), which operates psychiatric centers throughout the country. Vital Images (VTAL NASDAQ) makes software that is used to analyze CRT images–CAT scans and MRIs. Their software takes a variety of images and puts them together in a 3-D picture. Historically, it was used for only CRT imaging. It’s now being used for things like virtual colonoscopy and virtual lung diagnosis and in the future will be used for images of the heart as well. Martek Bioscience (MATK NASDAQ), which provides a line of enhanced infant oils which are used in infant formula to increase nutritional needs. E-Research Technology (ERES NASDAQ) provides software that helps with clinical drug trials by digitally recording electrocardiogram results for submission to the FDA. This solution is being strongly encouraged–if not mandated–by the FDA for clinical trial submissions, and E-Research is the low cost provider."

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