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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).

Still, don't despair: For every stock picker who interviews management, there is another who is skeptical of the method. "My own experience with talking to management has not been all that good," says Beverly White, editor of Emerging Growth Stocks, a newsletter published by Dow Theory Forecasts Inc. in Hammorid, Ind. "Not that I think managers are trying to be misleading, but they don't think the way the market thinks." Charles Allmon, who manages some $100 million in investment money and edits and publishes the newsletters Growth Stock Outlook and Junior Growth Stocks, agrees. "I get more information from a company's customers than I do from visiting plants," he says. "I call the suppliers, who might tell me that the company president is an alcoholic. If it's a restaurant chain, I go out and eat in it to see if I like the food."

What can't be avoided is a company's balance sheet. "Most people utterly ignore the balance sheet, particularly with new issues," Shepherd observes. "But just a quick glance at the assets and liabilities will often save you from falling in love with some concept. Do it right away before you start drooling and thinking this is a wonderful situation."

Among the points to ponder, most stock watchers say, are the following:

The current ratio of assets to liabilities. "Some of these companies are technically insolvent," says Shepherd, "and the reason they're selling stock is to bail them out of their misery." A good current ratio, the experts say, is three to one.

Long-term debt. If the company has a lot, it had better have other things going for it. "Most of the companies that were highly leveraged had a lot of difficulty in the last few years," Charles Allmon observes. "But a company with a good, strong balance sheet very rarely gets into trouble." What counts as strong? "At worst, a 20% to 25% ratio of long-term debt to shareholder equity," says Allmon. "The best is none at all."

Earnings. Allmon likes to see a 20% to 30% return on equity. Beverly White will settle for the high teens, but looks for "profit margins increasing on a year-to-year basis." Both experts consider multiyear earnings records. Allmon has even compiled what he calls a "Nifty 40" list of companies showing increased earnings and sales for a minimum of 10 consecutive years. Shepherd, whose newsletter focuses on smaller, younger companies without much of an earnings record, has to use more seat-of-the-pants reckoning. "You're not buying these companies on the basis of 5 years of earnings growth," he says. "You're hoping you can catch them at the beginning of the 5 years." One surrogate he uses in lieu of an earnings record is a company's backlog. If the backlog guarantees business for a year and a half or two years, he feels, the company might be a good bet.

Price-to-earnings ratios. "Some of these things are discounting the hereafter," says Allmon, who looks for P/Es in the 8 to 17 range. "I don't know of any other business whose customers refuse to buy something until it's been marked up 200%." Shepherd, who can't always find a meaningful P/E, considers the company's capitalization-to-sales ratio. A one-to-one ratio, he notes, is likely to be a bargain, and anything up to three-to-one is satisfactory. New issues, naturally, can seldom satisfy this criterion, and Shepherd tends to avoid them.

Growth rate. You need to check growth rates, Shepherd says, to analyze P/Es and capitalization-to-sales ratios correctly: "That tells you how fast they're going to catch up." Beverly White's rule of thumb is a 20% compound annual growth rate in sales over a five-year period.

A company's 10-K reports, filed with the Securities and Exchange Commission, reveal such tip-offs as pending lawsuits, the background and age of top managers ("I get a little leery if I see that everyone in management is over 60 or under 30," says White), and the extent of insider stock ownership (the more the better, up to a point). They also reveal the unexpected. "It didn't show up in the annual report, but one company's 10-K listed two very expensive yachts," recalls Shepherd. "The chief executive was using them for himself but keeping them on the company books. Needless to say, that disturbed me." Nor were Shepherd's concerns ill founded: The company, he says, later "went down the tubes."

It is not surprising that the first advice the pros offer to individual investors reflects their own positions more than anything else. Portfolio managers like Czepiel advise individuals to stay out entirely -- "you'll get your head handed to you" -- and instead put their money in a growth-stock mutual fund. Newsletter editors advise you to subscribe to their publications -- which, if you don't want to go to the trouble of picking your own stocks may not be a bad idea. Charles Allmon's Growth Stock Outlook, for example, has repeatedly ranked at or near the top of Mark Hulbert's investment-newsletter rating service (see INC., August 1983, page 122). The others mentioned here aren't rated by Hulbert.

Beyond that, however, the advice is commonsensical. Know what a company does and where it stands in its industry Diversify your holdings -- in particular, between high-technology and non-high-technology stocks. Be prepared to ride out stock and market cycles over a minimum period of three to five years.

"A lot of people don't understand what the risks are in this kind of investment, and don't understand that if you're going to play for big gains you're also going to suffer big losses," says Beverly White. "The best way to protect yourself is to be well diversified. I don't want to see somebody get wiped out because one or two stocks went bad."

"You step over carcasses all the time," agrees Charles Allmon, who thinks the Dow Jones Industrial Average could roll back to 1,050 or so before too long. "It's a terrifying experience to see what can happen to these things."

Bill Shepherd, although he spends his working days looking for small stocks to recommend -- and although he, too, fears a correction that he is "just going to ride out" -- has a philosophical approach. "Nobody's ever been able to improve on the investment advice offered by Will Rogers," he says with a chuckle." 'Don't gamble!' Rogers said. 'Take all savings and buy some good stock and hold it 'til it goes up, then sell it. If it don't go up, don't buy it."

Last updated: Jan 1, 1984




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