updated 1/21/2004 12:42:25 PM ET 2004-01-21T17:42:25

Opportunities in small-cap value are diminishing as the companies get swallowed up in mergers or else go private to shuck the hassles. What can you do?

Good small-cap value opportunities are getting scarce. The small-company Russell 2000 Value Index delivered a 41% total return in 2003, far outpacing the large-company S&P 500 (up 29%). There is no shortage of new small-cap stocks, but a lot of them tend to be tech shares that I normally don't favor. What I look for are well-run companies with consistent, predictable businesses, not shoot-the-moon gambles.

My focus is on both mid- and small-caps, and good ideas are more prevalent among the former. The mid-cap sector is littered with fallen angels from the large-cap growth arena that were ravaged by the three-year bear market.

For small companies--defined here as below $2 billion in market capitalization--the merger frenzy of the late 1990s helped reduce the herd. Those with strong brands made ideal purchase candidates for larger conglomerates and multinationals seeking strategic additions. Another factor is that many bite-size companies are going private these days, as a result of rising costs of Sarbanes-Oxley compliance. And fewer marketmakers and analysts are covering small-fry companies, which often makes their shares less liquid, and thus management is even more tempted to shuck the bother of public ownership. In addition, the recent recession has hurt many of their balance sheets, leaving them with much less financial flexibility.

Look at drug retailing. Only two small-cap chains are around now, Longs Drug Stores and Duane Reade. Yet Duane Reade has announced its intention to go private via a buyout by billionaire investor Robert Bass, which will leave us with one name. Back in 1993 eight small-cap drugstore chains were publicly traded: Arbor Drugs, Big B, Drug Emporium, Fays, Genovese Drug Stores, the Medicine Shoppe, Perry Drug Stores and Longs (Duane Reade wasn't public then). What happened to the rest? Arbor and Big B were absorbed into CVS, which did not even exist as a stand-alone public company a decade ago. Drug Emporium went bankrupt. Fays and Genovese are now Eckert, which is owned by J.C. Penney. The Medicine Shoppe was bought by Cardinal Health, Perry by Rite Aid. Food retailing, toy manufacturing, packaged food and household products are all businesses with similar declines in the roster of small-cap stocks.

Nevertheless, don't give up on small-cap value. Sit and wait for opportunity. Eventually the market will return from its lofty levels, so some of today's mid-cap darlings will slip into the small-cap category.

In the meantime, you can own ad agency Grey Global Group, whose Berkshire Hathaway-like disdain for stock splits shouldn't deter you; advertising revenue is coming back. A second opportunity is newspaper company Journal Register, owner of small papers in the Northeast with little or no competition and increasing ad volumes ahead. A third is home medical product manufacturer Invacare, with products like wheelchairs and respiratory equipment, which have built-in demand from an aging population.

Last year, slim pickings among small-caps aside, my best recommendation was Sybron Dental Specialties, marking a rebound from 2002, when it was one of my worst picks. Its 87% surge from when I wrote about it last February, resulting from new products and overseas demand, would brighten any investor's smile.

My next-best performer also was a small-cap: Sotheby's, up 50%. The auction market is improving, and the fourth quarter should be strong, with a return to profitability expected in 2004. In addition, memories are fading of its price-fixing scandal, which led to the conviction of former chairman Alfred Taubman. Stick with both stocks.

On the flip side, two of my biggest laggards were mid-caps: Interpublic Group, up a mere 2%, and Janus Capital Group, ahead 10%. Like Grey, Interpublic has a recovering ad market going for it. A sterling client roster and an improving balance sheet should help it out of the red.

Janus made unfortunate headlines in the recent mutual fund scandals. That said, I was encouraged by management's response and candor, and I believe the ethical lapses of certain individuals, no longer there, are not representative of the company. For contrarian investors, money still can be made with both Interpublic and Janus.

Overall, following my advice in 2003 would have resulted in a 26% average gain, with 1% included as a commission cost, or 4% better than similarly timed purchases of the S&P 500.

© 2012


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