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Insights: Finance

Micro-cap stocks are proof that great investment gifts can come in small packages
From the Print Edition:
Kevin Bacon, May/Jun 00

Micro-cap stocks (generally defined by Wall Street as publicly traded companies with market capitalizations of $300 million or less) represent the last frontier in the equities markets. With minimal Wall Street research coverage, the micro-cap sector offers exceptional opportunity for investors.  

Micro-cap stocks do not fit into any single category. They include young entrepreneurial companies in the forefront of technology and other fast-growth industries, established companies in more mature businesses, and niche companies serving smaller geographic regions and markets. There are approximately 15,000 micro-cap stocks, divided among the following broad industry group classifications: technology, 40 percent; manufacturing, 15 percent; banking and finance, 10 percent; mining and construction, 10 percent; utilities and transportation, 10 percent; and agriculture, real estate and insurance, 5 percent each. In other words, there is a little something that can turn into a big something for all kinds of investors. This is the "space" where we believe the next Microsoft or Berkshire Hathaway resides.    

THE RESEARCH VACUUM  

Wall Street pays scant attention to micro-cap stocks. This is not a reflection of their investment merit, but rather simple "sell side" economics. Micro-cap companies have small floats (shares outstanding) and therefore do not offer much in the way of trading commissions to the major brokerage firms. In addition, micro-cap companies are not likely to be raising large sums of capital in the near future. So, there is limited potential for investment banking fees. The end result is a research vacuum. Even the dullest S&P 500 company can have hundreds of Wall Street analysts following its every move, while the most dynamic micro-cap stock attracts little or no professional scrutiny.  

In the micro-cap arena, investors willing to do some digging can be the first to hit pay dirt. You often have to be patient. However, if you do uncover something truly special, it will eventually attract the attention of Wall Street and institutional investors, or a corporate buyer. When this happens, you can expect windfall profits.  

Of course, there is also risk. Some micro-cap companies are dependent on just one product or serve a very narrow market. Others lack management depth. If something goes wrong, there is often little to fall back on. Liquidity is also an issue. Owning a piece of a micro-cap company provides exceptional upside potential when things go right and everyone wants in. However, when things go wrong and everyone heads to the exits at the same time, you get trampled.   Risk/reward factors duly noted, micro-caps have outperformed every other equities capitalization sector over the 27-year period (1973-1999) in which micro-cap stock performance data is available, as the accompanying chart illustrates.    

RESEARCH, RESEARCH, RESEARCH  

It is said that the key to successful real estate investing is location, location, location. The key to successful micro-cap investing is research, research, research. As aforementioned, Wall Street doesn't provide much help. We at Gabelli Funds get micro-cap ideas from trade journals, annual reports, industry contacts, and even management of larger companies that we follow in similar or related businesses. In fact, we welcome ideas from Cigar Aficionado readers.  

Regardless of the source of ideas, we always do our own digging. We believe in sitting down with the management of most companies we consider investing in--we call it going belly to belly with Gabelli. It is a particularly critical facet of our micro-cap stock research. Annual reports, 10Ks and 10Qs can do a good job detailing what is, but meeting with small-company management and discussing their business plan and reviewing their business model is the best way to assess what is likely to be.    

FINDING CHEAP STOCKS  

In the micro-cap sector, growth and value are not mutually exclusive investment concepts. Because of the research vacuum, you can find dynamic young micro-cap companies in fast-growth industries (including technology) trading at very reasonable valuations relative to their larger-cap peers. You can also uncover wonderful companies in less glamorous businesses trading at just a fraction of their intrinsic value. Obviously, finding the next Microsoft is a potentially rewarding experience. But, let's not forget that Warren Buffett created enormous wealth for Berkshire Hathaway shareholders through opportunistically priced purchases of cash-generating businesses in industries such as newspaper publishing, candy and furniture retailing.  

When analyzing established micro-cap companies in more mature industries, we employ traditional valuation criteria. Our focus is generally on free cash flow (earnings before interest, taxes, depreciation and amortization, or "EBITDA," minus necessary capital expenditures), which we believe to be the best barometer of a company's "real world" economic value. We also look at asset value--not simply subtracting liabilities from assets (stated book value), but breaking down and recasting the balance sheet to provide a more accurate appraisal of on- and off-balance-sheet assets. When we find a good micro-cap company trading at a low multiple to free cash flow or well below asset value, we look for a potential catalyst--something happening in the target company's industry or indigenous to the company itself that will attract investor attention and surface value. Two of the most powerful catalysts in the micro-cap sector are deregulation and industry consolidation. This explains why our micro-cap stock fund, Gabelli Westwood Mighty Mites, is scouring the market for small utilities and community bank stocks.  

When analyzing younger companies in rapidly evolving industries like technology, we take a different approach, focusing on things like proprietary products and services, market size and growth rates, revenue growth, operating margins, "cash burn" (how fast the company is going through the cash required to finance growth) and prospective competition. Value is not generally as readily quantifiable, but we are still attempting to identify stocks trading at reasonable valuations relative to their growth prospects.  

One common characteristic of micro-cap companies is that management typically owns significant equities positions. So, whether management hopes to become rich by growing the company or by selling it, they may have a propensity to surface shareholder value.  

Leap Wireless International (Nasdaq, LWIN) is a good example of a dynamic little growth company with a big future. A spin-off from Qualcomm, Leap Wireless is a wireless communications carrier that owns and operates domestic and international CDMA (Code Division Multiple Access) networks. Leap offers flat-fee unlimited local calling plans in its domestic markets. Price and quality make this a competitive alternative to traditional wireline local phone service. As Leap continues to build out its networks and increase market share, rapid growth in customers, revenues and operating profits should attract more investor attention. Leap is no longer a secret--sorry, we got there first. But even after its exceptional performance in 1999, at its $78 5/8 per share price (as of this writing in the first week of March), Leap is still trading at a significant valuation discount to its wireless industry peers.    

GATOR BAIT?  

Changes in federal and state regulations are opening the utilities industry to future competition, and thereby forcing utilities companies to reduce their costs. The easiest way to accomplish this is by buying other utilities to create economies of scale. This has spawned rapid consolidation in the industry.  

Florida Public Utilities (Amex, FPU) is an electric, gas and water utilities company with operations in Palm Beach, mid-Florida, Marianna and Fernandina Beach. These are fast-growing markets, which we believe would be attractive to larger utilities companies in Florida and throughout the Southeast. At a price of $14 5/8 per share in early March, FPU is trading well below the price we believe it would fetch from an acquirer. In addition, the stock was yielding 4.7 percent, providing a financial incentive to own it pending future developments.    

BANKING ON IT  

The banking industry is also undergoing consolidation, with bigger banks swallowing smaller ones throughout the industry. So, there is some takeover flavor to bank stocks big and small. In addition, due to rising interest rates, bank stocks are currently out of favor. This has created some exceptional fundamental bargains.  

Vail Banks Inc. (Nasdaq, VAIL) operates 23 retail offices located primarily in the western slope region of Colorado. The company posted impressive gains in cash earnings (earnings excluding the amortization of intangible assets) in the fourth quarter and for the full year of 1999. At a recent $9 5/16 per share, Vail Banks trades at just 12 times earnings and at only 98 percent of book value. We are banking that investors will reward good earnings growth or a larger bank will spot this fundamentally appealing business bargain.    

TURNED AROUND  

Lamson & Sessions (NYSE, LMS) is a diversified manufacturer and distributor of a broad line of thermoplastic, consumer telecommunications, and fluid drainage products. Following a restructuring of part of the company in 1998 and the first half of 1999, Lamson & Sessions has posted strong performance in all its business segments. For the three months ended January 2, 2000, earnings were $0.78 per share compared to just $0.08 in the same period the year before. Investors have yet to notice this earnings turnaround, and at a recent $7 per share, Lamson is trading at just 6 times earnings. We view it as an outstanding "old economy" micro-cap stock bargain.  

Individuals comfortable doing their own investment research can come up with some interesting micro-cap ideas by examining little companies in their own neighborhoods. If you are looking for help, you might want to contact a reputable regional broker and take a look at its micro-cap research. A note of caution here: Be careful to distinguish between quality regional brokers and those "cold call" brokers from firms you've never heard of peddling "too good to be true" penny stocks. The former can be good sources for micro-cap stock ideas. The latter are predators adept at separating the unwary from their money.  

Through micro-cap stock mutual funds, investors can get more diversification and trading expertise--it is not easy accumulating shares in micro-cap companies, and large bid-and-ask spreads can make transactions very expensive. Morningstar and the mutual fund "supermarkets" will provide listings and performance data.    

Mario J. Gabelli is the founder and chairman of Gabelli Funds Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.

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