Where on the Inc. 100 list does the smart money go? We asked some of the country's hottest small-cap traders to tell us
No one ever said investing in fast-growing companies wasn't risky. In fact, after the walloping they took last year, small-company growth stocks are decidedly not for the faint of heart. But despite last year's volatile market, many growth companies surpassed earnings expectations in 1994, and some investors still turned big profits.
We asked several experts to analyze the stocks represented in this year's Inc. 100, and each analyst took pains to make this point: investing in growth stocks requires tons of due diligence, lots of patience, and faith that over time growth companies often reap the highest rewards.
In that light, the experts shared with us their top investment picks -- and their rationales. Several stocks were chosen by more than one investor, and usually for similar reasons. In most cases we decided to present only one adviser's analysis as representative of the rest. Here are the highlights:* * *
President and CEO
Driehaus Small Cap Growth Fund
Driehaus Capital Management
Assets: Manages $532 million, with a focus on small-cap stocks
Performance: An annualized return of 27.88% over the last five years
Top Inc. 100 Picks: Alantec, Alliance Semiconductor, PeopleSoft, Roberts Pharmaceutical, Wonderware
We're really growth buyers. We believe that earnings growth is the primary motive of all businesses and is crucial in determining common-stock prices over the long term. Everything else being equal, we look for companies with accelerating sales and earnings and what we call positive-earnings surprises, instances in which a company reports numbers that are sharply better than what the Street anticipated.
Alantec (#19) manufactures intelligent switching hubs for Ethernet and local area networks. It reported a strong quarter, ahead of earnings expectations, and revenues are up 113% from a year ago. We generally buy stocks that are increasingly attracting institutional interest, and we try to buy them earlier than most other investors do. Here's a company that's way ahead of plan and caused the Street analysts to raise their estimates. We feel Alantec's revenues can grow at about a 100% rate over the next several years. The company's long-term promise is excellent, and the market dynamics are very healthy. Also, Alantec's customer count is growing rapidly, the size of its orders is expanding, the sales cycle is shrinking, and its profitability is improving. And the company has made substantial investments in its infrastructure.
The industry outlook is important. We want to know if the industry outlook is better than, the same as, or worse than it was in the previous quarter. Two areas where you're going to see some improvement are health care and technology. In technology we're seeing a strong demand for personal computers, and it appears that the personal-computer business has left the phase of being part of a cyclical business and is becoming more like a consumer-electronics business. So tremendous computer power is being placed in the hands of individuals, and that, of course, stimulates demand for semiconductors.
Alliance Semiconductor (#39), a leading supplier of high-performance memory products, is another company we like. We're looking for upward revisions in which analysts raise the estimates sharply on a stock. Based on Alliance Semiconductor's very strong December quarter [earnings per share were 50% better than expected], the Street analysts raised their estimates this year significantly. The company employs a world-class design team focused on the high-volume mainstream markets, which have higher barriers to entry. That is where the company's engineering talent can shine. It's a well-positioned company. And I think the market is fully aware of its immediate and longer-term strengths. It's one of our favorite stocks.
We also look at companies that are reporting strong, consistent, sustained earnings growth. Companies that are more stable in nature have an above-average sector growth rate. Here we're talking about companies that are growing at a 30%-to-40% rate, and we're looking to make sure that the sales and earnings they've reported are going to continue.
Roberts Pharmaceutical (#10) is a company whose investments are now starting to pay off. The compound average long-term growth rate estimated by the Street for this company is between 40% and 50%, and earnings estimates are up by more than 70% from 1994. We think those figures may be conservative. We think there is a lot less risk in buying stocks that are heading higher based on new, positive information than in buying a stock that's heading lower and praying that it will turn around. For about a year and a half Roberts Pharmaceutical was going through a saucer bottom, in which the stock dropped down, but now it's coming back up and hitting a new recovery high. This is a very good company. It acquires and develops high-potential, undervalued, late-stage-development pharmaceuticals, and it's been good at it.* * *
PBHG Emerging Growth Fund
Pilgrim Baxter & Associates
Assets: Manages $265 million, with a focus on small-cap and microcap stocks
Performance: An annualized return of 38% since the fund's inception, on June 15, 1993
Top Inc. 100 Picks: Alternative Resources, Hollywood Entertainment, Network Peripherals, Papa John's International, Wonderware
We monitor a universe of companies very closely, looking for positive-earnings surprises, earnings and sales accelerations, and earnings-estimate revisions. We measure the strength of the balance sheet and earnings quality and basically try to pick up on trends early. We also look for companies that have shown at least 30% growth in sales and earnings in the most recent quarter. We assess whether there's a real growth potential with a long-term growth story. Then we'll begin to monitor the company and its expectations as well.
Wonderware (#56) experienced more than 60% growth in sales and earnings in 1994, and we expect the company to continue to grow by 50% in 1995. Its strength lies in its core product, software that allows engineers to monitor the manufacturing process as it's occurring so they can gain maximum efficiency and will be aware of any potential problems. Also, there's room for Wonderware to grow its installed base and enter different segments of the market. My portfolio is 40% technology because that's where we're finding all the growth companies.
Hollywood Entertainment (#23) is a video superstore like Blockbuster. It has a focused strategy. It does only video and video-game rentals and sales. It's also a cash-flow-positive business, and its return on investment for building new units and acquiring units is very favorable. Basically, Hollywood Entertainment is the only video superstore that has been able to compete with Blockbuster. The movie-rental market accounts for 50% of a movie's gross, so it continues to be an important channel for the movie-production houses.
Papa John's International (#68) is committed to doing only one thing, and that's pizza delivery. It has a rapid-expansion strategy that is well executed and focused. It's been able to expand the number of stores in markets without taking away from the sales of its existing units, so its sales per unit continue to go up, which means it's gaining market share from Pizza Hut and Domino's. The company's return on cash investment for each new restaurant is more than 100%. In 1994 the company's revenues grew by 81%, and earnings grew by 78%.
Alternative Resources (#83) also looks good. It provides personnel for specific technology projects. The company operates on an office model in which growth is generated through the opening of new offices and through the existing offices. It's a management-intensive business because you have to have good controls on your offices, which are responsible for their own profits and losses. Alternative Resources does a great job of hiring and motivating managers. It's in a growing market: as companies continue to downsize they will continually turn to people like Alternative Resources. Increasing the number of long-term partnering relationships gives Alternative Resources more visibility with its clients and a better understanding of their needs. In some cases Alternative Resources has taken over whole departments. It also helps keep turnover low and costs down. In 1995, 40% growth is expected in the company's sales and earnings.* * *
David and Thomas Gardner
The Motley Fool
America Online's Foolish Investors
Assets: Manage $50,000 of their own money
Performance: Up 11.03% since August 4, 1994, when the Gardners started investing
Top Inc. 100 Picks: Cisco Systems, Hollywood Entertainment, Network Peripherals, OfficeMax, Ventritex, Wall Data
In valuing small-capital growth stocks, we use the Fool Ratio. Essentially, what we're doing is comparing the price-to-earnings multiple with the company's earnings-per-share growth rate. We toss out all sorts of standard marketwide multiple analyses and assert that the price/earnings ratio cannot be judged in a vacuum. It's got to be compared with a company's growth.
It's also important that a company have enough cash to support its operations. Is it cash-flow positive? Earnings can be misleading, since the company can take on a huge amount of debt to grow. You've got to look over the balance sheet to make sure the company has positive working capital, and look at the cash-flow statement to make sure there's positive cash flow for the quarter. We also look for zero or very negligible long-term debt.
Cisco Systems (#62) has no long-term debt and plenty of cash on the balance sheet. We think it's worth buying because its sales growth has been phenomenal, and it's in the right industry. The automated-teller-machine-switching and network-management-software industries will continue to boom in the coming years.
Wall Data (#44), a connectivity-software company, also has no long-term debt. There's lots of cash on the balance sheet and high profit margins, around 20%. Its earnings-growth projections run upwards of 40% annually.
Cisco Systems and Wall Data saw their stock prices get cut in half in the summer of 1994. Since then they've come charging back. We always look for stocks that are going to double. We think that a year from now stock from both companies will be fairly priced at least 20% higher than it is now.
Network Peripherals (#5), another company in networking solutions, saw its stock price more than triple last year. We think by holding any one of these stocks for at least 24 months you're going to see market-beating returns.
Ventritex (#15) makes implantable devices that regulate the speed of the heart; the product launched the company into tremendous growth, but it showed negative earnings in 1991, 1992, 1993, and halfway through 1994. But we always take a long-term approach. The company recently turned the corner into profitability, and its earnings estimates are extremely strong. Also, it's a small company, which we like, and it has more than $100 million in sales, with no debt.
OfficeMax (#48) went public at the end of last year, and it was a successful initial public offering. We like it because it's a simple business, office-supply superstores, and it's recession proof. For obvious reasons, superstores are growing like crazy right now. They can guarantee low prices to their customers by ordering in huge volume, and they don't have to build lots of stores; instead, they have to find good real estate. Superstores have been doing excellent business over the last 5 to 10 years and have been some of the best stocks. This company is on a January fiscal year-end with estimated fiscal 1996 earnings per share of 95Â¢ and a five-year growth rate of 30%. Running its numbers through our magical foolish machine, I come up with a target price in the high forties.* * *
T. Rowe Price New Horizons Fund
T. Rowe Price Associates
Assets: Manages $1.7 billion, with a focus on small-company growth stocks
Performance: An annualized return of 13.25% over the last five years
Top Inc. 100 Picks: Boston Chicken, Lone Star Steakhouse & Saloon, Outback Steakhouse, PetSmart, Wellfleet Communications (Bay Networks)
As a growth investor I look for emerging companies early in their life cycle, companies I'd like to own as they grow larger and become more widely known. I tend to have a much lower stock turnover than the average small-company mutual-fund investor. [Laporte's portfolio turnover averages 40% to 45% a year.] I try to find good companies and stick with them.
Boston Chicken (#35) is an aggressively run restaurant company trying to exploit the take-home-meal market. Led by an outstanding management team, the company is quickly expanding its number of units. Also, it's in the process of evolving and expanding its menu beyond chicken, which will broaden the appeal of the restaurant and make it attractive for both lunch and dinner. It's one of the fastest-growing restaurants out there.
So are Lone Star Steakhouse & Saloon (#18) and Outback Steakhouse (#61). They're both growing earnings at more than 40% a year. Their average units do around $3 million annually, and they employ two of the best management teams in the industry. Currently, Lone Star Steakhouse & Saloon is looking for another small restaurant chain that it can roll out over the next five years in addition to its existing business, while last year Outback settled on an Italian-restaurant concept, which it will expand along with its core business.
Wellfleet Communications (Bay Networks) (#24), a company that makes products that connect networks, is riding the strong PC-shipment wave and taking advantage of the increasing desire of PC users to communicate with one another. The result of a merger between SynOptics Communications and Wellfleet Communications, Bay Networks operates in an exciting sector of the technology market and is positioned to take advantage of that technology growth.
New USA Mutual Fund
New USA Research & Management
Assets: Manages $175 million, with a focus on growth stocks
Performance: An annualized return of 3.14% since the fund's inception, on April 4, 1992
Top Inc. 100 Picks: Boston Chicken, Lone Star Steakhouse & Saloon, PeopleSoft, PetSmart, Steris
We're looking for the stocks with the strongest acceleration in earnings combined with consistent earnings growth of more than 20% to 25% annually. Also, we like to see quarterly earnings coming in at that rate or higher, because that's where you get a consistent growth stock that will continue to grow.
PeopleSoft (#59) has 1995 estimates that show earnings increasing by 42% and then by another 37% in 1996. And PetSmart (#94) has had earnings increases of more than 100% for three out of the last four quarters, compared with corresponding quarters of the prior year. Even though it's trading at a real high multiple, its earnings are going to increase 90% in 1995 and 112% in 1996. One hundred and forty-six superstores are up and running, and PetSmart just acquired superstore retailer Petstuff, which had around $77 million in revenues.
Once we've gotten the fundamental story and checked the earnings, we also want to make sure that recognition of those earnings is being reflected in the marketplace. We want to see a strong stock in terms of price action. How well is that stock performing, versus all the other stocks in the market? We want it to be in the upper quartile in terms of price performance over the last 12 months.
Boston Chicken (#35) is a company I'd keep my eye on. You're talking about a high multiple on this stock, and it will have earnings growth in 1995 of 44% and in 1996 of 36%. Boston Chicken has about 250 franchise restaurants and is rapidly expanding. It's a situation in which the company is well known and very hyped, and the stock has been going sideways while the earnings are really ramping up, bringing the valuation of the company down. The quality of the restaurants is good, they're neat and clean, and these things are springing up all over the country.
Steris (#86) also looks good. It's had consistent earnings growth of about 73% over the last three years. It has great estimates for 1995 and 1996. Also, it just came out with a new product called EcoCycle, designed to remove biohazardous hospital waste. I would probably recommend Steris because it's had a nice run-up, but it's probably going to have to put in some time for another couple of months.