Picking The Right Small Stock

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If William G. Shepherd Jr. owned all the stocks he has recommended in his newsletter, Ground Floor, he might be worrying about the Mexican peso, or about how Sears, Roebuck & Co.'s noontime trade was holding up. He would have investments, you see, in a small, growing airline serving the Hawaiian islands and in a family-run chain of sandwich shops in the Southwest.

If the connections between the worries and the investments seem obscure, they aren't. Devaluation of the peso encourages U.S. tourists to visit Mexico instead of Hawaii. The sandwich-shop chain is making money because of its restaurant concessions in a growing number of Sears stores. But both prospective purchases illustrate how buyers of small-company stocks can be held hostage by broader trends and bigger institutions. A blip in currency rates or big-company marketing strategies, among dozens of other uncontrollable events, can turn growth into groans overnight. And a dip in the market itself can send small stocks plummeting while big ones move lazily downward.

So why does any stock buyer venture farther afield than the Big Board? The answer is in the numbers. Shepherd wrote up the Hawaiian company, Mid Pacific Airlines Inc., when it was at 2 3/8. It rose to more than 18, fell to 10, and, at this writing, seems likely to rise again. The sandwich-shop chain, Primo Inc., was at 1 1/4 when Shepherd found it, and had risen to 9 3/8 a year and a half later. There, as Willie Sutton might have said, is where the money is. Find a small company that is about to take off, and ride its growth curve upward.

If only the job were that easy. There are many thousands of publicly traded companies in the United States, most of them relatively small. Many of the hottest prospects have already been discovered, and their stock prices bid way up. What you want are the companies that might some day be hot prospects but for the moment are laboring in relative obscurity The challenge is to find them, evaluate them, and finally, try to separate the few that might make it from the many that won't.

One shortcut, of course, is to subscribe to newsletters like Shepherd's that do the picking for you. That strategy doesn't necessarily mean you will have a lot of company in your investing; although some newsletters have big followings (and can therefore move the price of a stock through their recommendations), there are plenty that are well respected but small. Still, what might be more fruitful is to listen to what a sampling of newsletter editors and other professional growth-stock pickers have to say about their trade. Like veteran horse players, they have different systems. But they agree on a lot, too, and in those areas of agreement lies a sort of professional consensus about the ins and outs of small-company investing.

Oddly enough, the easiest part of the job seems to be coming up with names of prospective investments. "Maybe you meet an executive of a company at dinner," says Robert Czepiel, who manages Cigna Corp.'s special-opportunities portfolio. "He tells you about a product that is being supplied to him on a timely and cost-effective basis. You look into it." A mutual-fund manager found one of his favorite stocks, Chemlawn Corp., after he had admired a neighbor's grass "I decided to try these Chemlawn people," the neighbor told the manager, "and within a year the thing looked like a golf course." Small-business people are often well situated to turn up ideas by this eyes-and-ears method. Suppliers, customers, company lawyers, and accountants are good people to talk with first.

What to look for? A popular notion among the pros is to identify a company that occupies a unique niche in the marketplace. Frederick Simmons, president of Massachusetts Financial Emerging Growth Trust, likes a company called Comdata Network Inc., which offers an electronic funds-transfer system specifically designed for long-distance truckers, who otherwise have to carry large amounts of cash. He also likes Safety-Kleen Corp., a company that supplies other companies' facilities with machines that clean parts and equipment. Both, Simmons says, have little competition.

Another popular notion is to follow a sort of funnel from a fast-growing but unpredictable industry -- personal computers, say -- back to the suppliers that all of its participants depend on. "The way the market is now, I wouldn't buy shares in any personal-computer manufacturer," says Bill Shepherd "It's too competitive, too crazy, and the price cutting's wild. I'm also leery of Winchester disk drives, because the companies that are most successful there are too well known. But take a little company called Xebec, which makes Winchester disk-drive controllers for small computers. Or Key Tronic Corp., which makes keyboards for many well-known small computers. No matter who wins, they're going to be getting the business."

Cigna's Czepiel carried the idea one step further. He bought Verbatim Corp., a leading floppy-disk manufacturer. Then he began looking at the companies that manufactured parts for disk drives. "It gets down into a bottleneck," he says. "All personal computers require disk drives and all disk drives require magnetic heads. So if you can find a company that manufactures a magnetic head, you're leveraging off that fantastic growth. Well, it turns out there are only three independents. National Micronetics, Applied Magnetics, and CCT. And the business of those three companies is literally exploding."

One point the stock pickers agree on, though, is that technology or market niche by itself is never enough. "What most people do is fall in love with a concept -- the idea for a product -- then they go and buy the stock," says Shepherd. "But what really counts is the company's management. It's one thing to create a great product, it's another to market it." Czepiel concurs: "Smart management will acquire technology," he says, "but a smart engineer will not always bring in good businessmen."

To evaluate the management, a lot of the pros rely on in-depth interviews with the top people. As an individual investor, you can't expect a two-hour meeting with the chief executive officer unless you have an entree through your business dealings (or unless you have a lot of money to invest).

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