Small Is, Finally, Beautiful
Underappreciated for years, small-company stocks finally exploded intoinvestment favor in 1991. Will their newfound preeminence last?
While the country's largest public corporations -- General Motors, IBM, Westinghouse, Woolworth, and the like -- are coming apart at the seams, its smallest have been putting on quite a show of strength. Small-capitalization corporations -- those whose market value is a few hundred-million dollars or less -- enjoyed their best stock-performance year ever.
In 1991 the blue-chip 30 Dow Jones Industrials gained 20%. But the Dow wasn't where the action was. The real movement was in the automated over-the-counter market, NASDAQ, where at the close of the year the average market value of a listing was $126 million, or approximately one two-hundredth of GM's. The NASDAQ Industrial Average soared a monumental 65%. Similarly, the Hambrecht & Quist Growth Index, composed of about 100 companies with market values of less than $200 million, surged an even longer 94%. Trading on NASDAQ soared to 41.3 billion shares (a record), and dollar volume to $694 billion (ditto).
Small-cap stocks' climbing to record heights suggests a fundamental shift in investors' appreciation of our economy's future. Previously chary of the risk inherent in small-cap corporations -- and of in-and-out liquidity problems due to their relatively low number of outstanding shares -- many an institutional trading desk hired a small-cap money manager in 1991.
Why? Not because they suddenly discovered that growth-oriented management was more alert. Or that small companies could adapt to change faster, grab market share faster, create new products faster, bring them to market faster, start selling them faster, cut fat, trim overhead, go lean and mean -- those abilities they already knew about.
What investors realized was that, almost without exception, small-cap operations were bringing the bacon back home. Such companies thrive best where the rest of the globe hasn't yet dared venture. In 1991 small-cap hot spots included regional health care and delivery, biotechnology, software, computer mail order, specialty retail, and telecommunications -- nary a VCR, TV, slab of steel, or side of beef to be found. Save for the silicon-chip business every now and again, no industrial sector populated by small public companies was so desperately inept that the government had to drag a bevy of underinspired and overcompensated executives across the Pacific to bitch about it.
So let Japan have its MITIs and hierarchies. Big money's eager endorsement of small, non-dividend-paying companies in 1991 recognizes that pure capital gain is itself a rewarding concept. Forget the Nifty Fifty. Forget total return. Growth companies that plow income back into operations constitute a far more sensible investment than behemoths that have no better plan for capital than to raise CEO salaries.
Indeed, our entrepreneurial hockey-stick growth curves are the envy of the Japanese, who for half a dozen years have been trying to light the spark of innovative enterprise under their own worrisomely flattening economy.
They've had little success. So little, in fact, that plenty of U.S. small-company executives have been invited to teach them how to sow seeds properly. We may not be selling them any cars or fridges, but our growth-strategy know-how sure is in demand.
And no wonder. Businesspeople here run clever, raised-on-their-own-nickel companies such as -- to name a few mentioned previously in Inc. -- Symantec, up 233% in 1991; Borland International, up 159%; Ben & Jerry's Homemade, up 151%; Paychex, up 89%; and Dell Computer, up 39%.
By contrast, GM and IBM -- which you have not read about in these pages -- lost 16% and 21%, respectively. Not to mention 114,000 jobs. -- Robert A. Mamis
Relative Market Performance
Industrial average 3/1/91 2/28/92 % Change
INC. 100 11.8 18.7 +58%
NASDAQ 510 722 +42%
AMEX 348 416 +20%
DJIA 2,910 3,268 +12%
S&P 439 491 +12%* * *
Better private-equity markets, more venture capital, increased eagerness among prospectivebig-company partners ? How the stock market's enthusiasm will change your small company's life
At the heart of the bull market for small-capitalization stocks lie forces that will favor small companies in the years ahead and in turn will reshape the economy in their image.
"Every bit of evidence shows that two things are happening. The size of economic units that do productive things are getting smaller. And the number of those units is increasing,' observes Paul Reynolds, a professor of entrepreneurship at Marquette University. These trends are part, he says, of "a fundamental shift in the economic structure, which will not reverse itself in my lifetime.' Large companies such as IBM, to take a prime example, will never again look the way they did in the 1960s and '70s. "If IBM regains its profitability and market share, it's not because it will hire more people, but because it used fewer people and used them smarter,' he predicts.
The increasing importance and numbers of small companies owe to a series of intertwined factors. Together, they exist as portents that are hard to ignore. Here is a look at some of these present causes and future consequences, presaged by the current bull market for small-cap companies.* * *
With IPOs again offering lucrative exits, early-stage investment will revive
The hot market for small-cap stocks and, in particular, for initial public offerings signals the gradual return of venture capital to its original mission: the funding of early-stage start-up companies. That is a role U.S. venture capital increasingly abandoned after the collapse of the IPO market in 1984. As aversion to risk grew inversely to the decline in returns, venture capitalists became glorified investment bankers. Innovative young companies, starved for cash, died on the vine -- or sought out more patient and venturesome Japanese investors.
Now that process is unwinding.
"The higher valuations for small-cap stocks will encourage venture capitalists to get back into earlier-stage investments. The window is open again,' says Dan R. Garner, national director of entrepreneurial services at Ernst & Young, in Dallas. The robust market for IPOs in 1991 offers venture backers of small companies a viable exit and thus sufficient incentive to assume the attendant risk.
That gives hope not just to investors, but to entrepreneurs as well, notes Bill Bygrave, a professor of entrepreneurship at Babson College. "A healthy IPO market effectively lowers the cost of capital to start-up companies,' he says. "Entrepreneurs get a higher price for their stock and have to give up less of the company to get it.'
Bill Hambrecht, president of the San Francisco venture-capital firm Hambrecht & Quist, cites two more factors that will favor small, innovative companies: low interest rates and the failure of the debt-driven financial strategies of the '80s. "Fund managers can afford to sit out the market when they can get 8% or 9% on their money,' Hambrecht notes. "But if they do that at 3% or 4%, they get fired. If you want above-average performance, you have to look for above-average growth in earnings. And that means you have to look for small companies.'
Meanwhile, he adds, the '80s emphasis on borrowing placed a premium on tangible assets. "That was something banks were comfortable lending against.' That bias favored large, mature companies at the expense of small ones whose key resources were locked up inside of people's heads. Now in a climate of asset deflation, small, knowledge-based companies have returned to favor, and that, he says, "has brought us back to a level playing field.'
The return to a more classical form of venture capital will, meanwhile, stimulate related forms of alternative investment that languished in the late '80s, as lending grew more institutionalized. Prime among those are business angels -- well-heeled individuals who privately place their money in small companies. With funds believed to outstrip the formal U.S. venture-capital pool of $36 billion by roughly 10 times, angels tend a huge, murky pool of cash. Until lately, though, some of that money has been frozen out of the investment process. In the current climate, in which exit opportunities are improved by the newfound strength of small-cap stocks and IPOs, angels will come back. Take the case of Dick Morley, an angel based in Amherst, N.H.
In the past, as Morley's investments matured and required additional funding, he brought in venture capitalists to make early-round investments and boost start-ups to their next level of growth. By the late '80s, though, those venture-capital investors had all but disappeared. "We had no one to hand our investments off to,' he says. "This process is a food chain. And suddenly there was a missing link.'
Venture capitalists, ready to do early-stage deals again, will reappear and reforge that missing link, Morley predicts. The average annual return on the top quartile of U.S. venture capital over the past two decades was 29.3%, according to Venture Economics Investor Services. That, Morley notes, offers ample investment incentive. "The recession will someday end, companies will again be healthier, and investors will look for places to get a higher return on their money,' he says. "Venture capital has been proven to be one of the best vehicles to do that.' The process that Morley describes is the deinstitutionalization of investing, whereby angels and other nonconventional investors who create companies will be on a much more equal footing with the New York City pension-fund managers. "In the next five years venture capital -- not investment banking -- will be resurrected,' he predicts.* * *
The Private Equity Market
Money will find less conventional -- and eventually more liquid -- forms of investment
The rise in small-cap stocks and the resurgence of venture capital offer signs of the renewed flexibility in the financial markets to which Dick Morley alludes. Money will again search out less conventional -- and seemingly less liquid -- forms of investment. One universe money will move into is that of small, private, low-tech companies laboring quietly in the backwaters of the economy, heretofore ignored by mainstream investors. Those companies are not just overlooked; they're undervalued, says Stanley E. Pratt, managing partner at Abbott Capital Management, in Needham, Mass.
"I think we're about to tap into the enormous potential of private companies,' Pratt says. He labels the process "controlled investment' as opposed to the sort of less controllable investment that often results when a small company meets the shifting moods of the public stock markets. Pratt sees a parallel stock market arising in the private sector, offering the best of both worlds: planned liquidity for investors and, for management, a buffer from the short-term pressures of the public market's caprice. Management in those small companies -- newly infused with outside capital -- will have the time, money, and peace of mind to devise long-range plans and build equity that won't get clobbered with the first quarter that turns down, he says.
Yet an exit will exist, keeping investors and managers motivated to keep return on investment high. In fact, Pratt argues, the exit options will be varied enough to provide increased financial flexibility. "After a few years you can bring in new investors and take out the old,' he says. Alternatively, investors could take the company public for a while and cash out some of their gains before going private again to recapitalize and plan for the next phase of growth.
The money to do such private-equity deals is definitely there, Pratt says. The pool of private-equity partnerships in the United States currently totals about $71.5 billion. The sum seems huge, but it could one day be greater. Pension-fund investments in the largest 3,000 U.S. public companies amount to $2.5 trillion. As money migrates to the highest returns, Pratt believes that even huge pension funds, currently constrained by fiduciary responsibilities to invest in large, liquid companies, will break off chunks of capital and find ways to work them into more niche markets.
Finding targets for that money will be no problem. Pratt recently searched a database of all The Dun & Bradstreet Corp. companies in the United States and found 133,000 with annual revenues of more than $10 million, and 117,000 of those were private. At the low end of the scale, he found 82,000 companies in the $10-million-to- $25-million range -- and 77,000 of those were private.
Steven P. Galante, publisher of The Private Equity Analyst, a newsletter that tracks private-equity investment, echoes Pratt. "Right now there's a strange dichotomy between the valuations in the private market, which are very fair, and the companies that are being funded in the stock market at high valuations.' As more venture investors exit their current deals at favorable valuations -- which then translate to the private market -- greater parity between the two is likely, Galante says.
Stanley Pratt states the case more forcefully -- and from a different perspective. "Smaller businesses have always had the potential to be more effectively managed,' he adds. "Now we are finding ways to create operating and strategic partnerships to bring that about.'* * *
The Small Company
Flat, fast, and here to stay, small businesses will become still more prominent
The quality of the IPO market is far higher this time around than during the big boom of the early '80s, Pratt asserts. "At this point 70% of the companies that went public in 1991 are higher than their IPO price,' he says. "By June of 1984 only 20% of the companies that went public in 1983 were higher than their IPO prices. A lot of quality companies are coming public now.' Pratt sees such quality as a harbinger that small companies have value for intrinsic, not just psychological, reasons. In short, the market is saying that small companies will become more permanent -- and more prominent -- fixtures on the economic landscape than currently imagined.
That notion is borne out by the research of Steven Davis, who teaches business economics at the Graduate School of Business at the University of Chicago. Small companies have in fact had a greater role to play since 1970, when large U.S. corporations began to shrink their payrolls, he says. "Two fundamental trends over the past 20 years have made small businesses more important,' he says. First, the shift from manufacturing to services has created a constellation of suppliers to larger companies. Second, the globalization of the economy has forced U.S. manufacturers to produce goods of higher value with fewer, better-trained, and better-paid workers.
That has led not only to the breakup of large companies into smaller units, but also to the creation of companies that need to remain small and flexible to survive.
Staying small and flexible is now possible because the increasing affordability and access to computer technology has given small companies a competitive advantage they previously lacked, says Bill Bygrave of Babson College. "Twenty years ago the only companies that could afford technology were big companies like Sears and General Motors. Now the smallest company can put in a powerful computer system cheaply.'
The cost of computer technology will continue to tumble, allowing smaller companies to achieve the leverage and results of larger organizations, without the bureaucracy, Bygrave says. That will give rise to more and more organizations oriented around what he calls the four Fs: flat, fast, focused, and flexible. "The notion of scale economies will be overthrown in the 1990s,' he says.
Support for Bygrave's conclusion can be found in the growing efforts by large companies to develop networks of small and agile suppliers. As large companies endeavor to do more business with small ones, the contributions of the latter will become more legitimate and valued.* * *
Eager big companies will become a growing source of patient development capital
Bill Bygrave likes to makes a distinction between the words innovative and entrepreneurial. Many large companies, plowing large sums into research and development, are plenty innovative. They are not, however, very entrepreneurial, by which he means "in touch with the market.' They do not know how to cash in on their innovation effectively. Big companies increasingly are moving to rectify this weakness. For example, in 1991 IBM entered into at least a dozen separate strategic alliances with software companies from Apple Computer Inc. on down.
The need of big companies to form joint ventures with small companies will only grow, says Edward Roberts, a technology-management professor at the Massachusetts Institute of Technology Sloan School of Management. He gives two related reasons. First, the rapid pace of technological change confronts corporations with "an increasing number of technologies to be mastered.' The most practical way to do that is to engage the skills of small, technology-based companies focused on niche markets. For example, Roberts recalls a former graduate student, now working as Microsoft Corp.'s product manager for pen-based technology, who recently stopped by to see him on a visit to Boston -- he was in the midst of calling on the seven companies in the area with which Microsoft has joint-venture agreements. Second, Roberts says, large companies in a competitive global economy realize they must return to their "core competencies.' They must focus. That heightens the need to rely on small suppliers.
The resulting benefits for small companies are considerable. They gain improved access to a steady stream of patient development capital. They gain access to channels of distribution that are often global in scope.
Roberts sits on the board of one such small player, Advanced Magnetics Inc., which develops contrast agents that are used in magnetic-resonance imaging of the body. Annual sales total a little more than $12 million, yet "much of the board's time is spent discussing alliances with large companies,' Roberts notes. For good reason. Advanced Magnetics currently has strategic alliances with six major pharmaceutical companies on three continents.
Big companies search out small ones for one basic reason, believes Advanced Magnetics CEO Jerry Goldstein: they are more innovative. Beyond that, the leverage for big companies is huge. Last year Bristol-Myers Squibb Co. entered into an $11-million transaction with Advanced Magnetics, developing products targeted at billion-dollar markets. "Bristol-Myers is a $10-billion company,' says Goldstein. "To it, $10 million is inventory breakage.' For these reasons, Goldstein sees strategic partnering as "absolutely increasing' in the years ahead. As an example, he cites Sandoz Corp., the Swiss pharmaceutical giant, which budgeted $1 billion for strategic alliances with small biotechnology companies.
A network of strategic alliances will also proliferate in all industries and for more down-to-earth reasons, asserts Paul Reynolds of Marquette University. Some of those reasons include the improvement in communication systems, the rebuilding of the infrastructure, and the institutionalization of just-in-time manufacturing. "All those factors make it easier for large companies to create linkages with outside suppliers.'
That jibes with the model that James Womack envisions. Womack is an MIT researcher and coauthor of The Machine That Changed the World, a book that chronicled the rise of the top Japanese car companies through their use of lean manufacturing techniques. Large, vertically integrated companies such as GM have failed, Womack asserts, "because you can't replicate the market's discipline inside a bureaucracy.' By the same token, Womack considers the vision of the lone entrepreneur trying to compete in a global economy as "naïve and romantic.' Womack argues for a "shared destiny' between large U.S. companies and their small suppliers in which information -- particularly concerning costs and technical know-how -- is exchanged more freely. That will result in greater trust and sense of mutual dependence -- critical factors in a world where the United States, in the aftermath of the Cold War, must now project economic, not military, power. "We're now living in a commercial world, not a geopolitical one,' says Womack. "Big and small companies need to work together in a more dynamic fashion.'* * *
The Entrepreneurial Alternative
Starting your own company is becoming a more viable career path
Between 1980 and 1990 the Fortune 500 companies shed some 3.5 million jobs. Yet the economy in that time created some 23 million jobs. "In the United States there's a real driving force for people to get started in their own businesses,' says Bruce Kirchhoff, who studies business formation at Fairleigh Dickinson University. In fact, even during the depths of the 1981-82 recession U.S. businesspeople were starting companies at a healthy clip. "Americans seem to form businesses no matter what,' Kirchhoff says. "People chug along. The human driving force is stronger than the economy.'
In the years ahead economic reality may well hasten the need for people to keep on chugging. As Paul Reynolds points out, "For large companies now, their biggest fixed investment is not plant but people.' Translation: big companies will continue to shed jobs.
And the people who lose those jobs will consider becoming entrepreneurs more seriously than ever. Rick Burnes, a venture capitalist who sees entrepreneurs coming out of larger companies, adds, "People are more willing to take risks because so many theoretically stable companies are now not so stable. Going out on your own and starting a company is becoming a more viable career path.'
Meanwhile, Paul Reynolds notes, "about one in five U.S. businesses is created or destroyed every year. That's one in eight jobs offered by private-sector employers. The evidence shows that is just part of life in a dynamic economy.'
A healthful by-product of dynamic growth, however, is more than just new jobs and vibrant companies. It is also a fresh perspective. As old contracts -- lifetime corporate employment, say -- wither away, new ones are forged.
Dick Morley, the angel investor, sees a return to investing at the grass-roots level as more than evidence of the economic principle of money chasing the highest return. It also reflects an increased awareness of where that money is going. "Venture capital has historically failed when it becomes a totally financial game,' says Morley, who believes the game is changing for the good. "What we do is return some funds to the community. A union pension fund that ends up investing in a small start-up wants to create jobs, not just move them around.'
Then he adds one last thought: "Besides, this is also fun.' -- Edward O. Welles n