Small Growth Stocks Look Even Cheaper

06/12/2008 12:00 am EST

Focus: STOCKS

James Oberweis

President, Oberweis Asset Management, Inc.

James Oberweis, editor of the Oberweis Report, says small growth stocks will outperform in the long run no matter what the economy does-and he recommends two.

We've just finished earnings season for the second quarter and we were shocked to learn that most of our portfolio companies had indeed managed to keep their lights on.

Actually, most did a lot better than that, posting generous year-over-year growth, in many cases well in excess of 30% increases. Usually investors have to pay a very high P/E for that kind of growth. But, as usually happens after a good walloping in the stock market, it just isn't the case today.

High-growth small caps remain quite cheap by historical standards. The Oberweis Universe P/E, which measures valuations of small-cap companies growing faster than 30% per year, was 22x [before the recent sell off,] compared with 21.7x at the end of March. This compares to an average of about 30x over the last five years. [Even] if stock prices rise but earnings rise even more, stocks become cheaper despite a nominal increase in prices.

Therein lies the obvious: Time is your friend. If stock prices go nowhere, and if companies produce moderate growth in earnings over time, equities can become remarkably cheap. We believe that many of the issues [we follow] will likely be less sensitive to macroeconomic conditions than you might think.

These are niche plays-their success or failure is dependent on gaining market share or creating new markets, not on if the US economy grows 3% or retracts 1%.

Starent Networks (Nasdaq: STAR) provides hardware and software solutions that enable wireless carriers to deliver multimedia to mobile devices. The company's products are best of breed and deliver the functionalities of both a server and a router in one device, which provides a less complex network architecture than traditional solutions.

Starent is benefiting from wireless carriers' shift to "value-added" multimedia as part of their service offerings and the shift to 3G mobile phone technology. In the company's latest reported first quarter, sales increased approximately 103% to $56.2 million from $27.6 million in the first quarter of last year. Starent reported earnings of 18 cents per share in the latest reported first quarter, versus seven cents in the same quarter of last year. (The stock closed below $16 Wednesday-Editor.)

True Religion Apparel (Nasdaq: TRLG) designs, manufactures and markets True Religion Brand Jeans. Its expanding product line, which includes high-quality distinctive styling and fit in denim, sportswear, and licensed products, may be found in premium department stores and boutiques in 50 countries around the world.

In the company's latest reported first quarter, sales increased approximately 47% to $53.4 million, from $36.2 million in the first quarter of last year. True Religion reported earnings of 29 cents per share in the latest reported first quarter versus 22 cents in the same quarter of last year. (The stock closed above $25 Wednesday-Editor.)

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