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Targeting Value Stocks in the Small-Cap Arena

If you're looking for value stocks, you might try looking in unexpected places - small-company technology stocks - for instance, Frank Russell Company’s Small Cap portfolio manager, Erik Ogard says.

Tuesday, January 15th 2002, 12:27PM

He believes some small-cap stocks offer exceptional value. The reasons: Pricing inefficiencies occur more often in small-cap than in large-cap stocks, and many small-cap stocks are valued at lower levels than their large-cap counterparts.

Most people think of small-cap stocks as growth stocks only. But, Ogard takes a more balanced view and acknowledges that small-cap companies come in all styles and exist in all economic sectors.

Choosing the best value small-cap stocks to buy poses risks as well as potential rewards.

"You should not buy small-cap stocks simply because their valuations are low," Ogard says. "Such valuations might suggest a company is facing serious operating challenges. Nor should you buy them just because they are cheap."

To find value stocks, you need to know how to evaluate what a business really is worth.

"You have to do your homework," says Ogard. "For example, a company may have a division that's about to dominate the marketplace. You have to ask yourself, 'If I were a business person, would I buy this company for a particular piece of its business?'

"Investors can read a balance sheet to determine a company's current value," Ogard says, "but they may not be able to identify a company's real potential."

Differentiating small-cap stocks that are deservedly cheap from those that offer compelling opportunities is a potentially rewarding investment approach. Yet few investment professionals — let alone individual investors — have a track record of discovering these kinds of opportunities.

Ogard cites Ben Nahum of David J. Green & Co., New York, a Russell high-ranked US small-cap equity fund manager, as one who has such a track record. Russell's Investment Management Group (IMG) monitored Nahum's performance for several years as he bought deeply discounted stocks of companies in economically sensitive sectors, such as technology, and secured impressive rates of return.

Today, Nahum is one of a number of investment managers tapped by Russell to manage a portion of its assets that are directed to the small-cap value segment of the market within Russell US equity funds.

The "contrarian" philosophy
While investors tend to follow the markets, Nahum advocates going against the grain. "In periods of transition," Nahum says, "share price movements tend to be exaggerated. The contrarian focuses on sectors in which stock prices have dropped, identifies specific companies with sound valuation characteristics and makes a long-term commitment."

Three technical factors determine attractive valuation, according to Nahum; low price-to-book, cash flow and earnings. Investors must do more, however, to identify true value opportunities.

Nahum pays close attention to mergers and acquisitions because they reveal what knowledgeable business leaders are paying for similar values. He draws the analogy of a real estate broker comparing home sales in a neighbourhood to determine a particular house's worth in the marketplace.

Nahum also places multi-divisional companies under the microscope. "You have to take these companies apart," Nahum says, "and ask, 'What is each piece of the company worth as a stand-alone business?' " Divisions must be compared to single-industry companies performing the same functions and currently being publicly traded.

Putting high P/E ratios into perspective
It's no surprise that Nahum prefers the lowest possible price/earnings ratio to determine value. But there are occasions when investors should be prepared to pay higher multiples in exchange for long-term opportunities.

For example: If cable operators are generally willing to pay 15 times cash flow for a cable property, and a cable property can be found at 10 times, that may be very attractive, even though the P/E is high.

Such a company may be able to increase returns through better yields on capital spending. A company with two components may sell a weak one, then reinvest its new capital in more profitable areas related to its high-performing component, thus increasing its intrinsic value.

Diversification adds value to a managed fund, Nahum maintains, but not to most companies. "The market doesn't like a business investing in many other businesses that don't do well. The market can diversify for itself and prefers that a company focus on what it does best."

Macroeconomic factors also require investor attention. The best corporate strategies can be rendered ineffective in a slow economy that inhibits growth. Moreover, a company's value can plunge when its products or services become commoditised, unless markets grow rapidly, creating a rising tide that lifts all competitors.

A sense of long-term opportunity
Numbers, Nahum points out, represent only a starting point for investors who must be intimately aware of a company's management — a task usually undertaken only by professionals.

"A company's competitiveness and strategic attempts to create shareholder value must be identified," he says.

In this regard, portfolio managers can hold a clear advantage over individual investors. Nahum spends most of his time travelling and getting to know top executives. Investors can not gain anything comparable in the way of access to the executive suite and the insights it offers.

Ultimately, however, Nahum does not rely on an algorithmic formula for success to find exceptional value in small-cap sectors. After running the numbers, he relies on his inner sense of where opportunities lie. This approach requires both experience and patience in the face of short-term earnings and share price worries.

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