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Wall Street, California: Midyear Review and Outlook
| STREET STRATEGIES

Lull in the Small-Cap Sector Could Be an Investor Opportunity

June 30, 1998|WALTER HAMILTON

Believe it or not, there is some good news about small-cap stocks.

Sure, they've lagged large-capitalization issues for four years and investors are showing little urgency to jump back into the sector.

But in a market environment like this, it's easy for individual investors to overlook three critical facts.

First, some small-caps have done quite well despite the woes of the broad sector.

Second, the sector itself will come back into favor--it always does--and whenever that happens many other stocks will spring to life.

Finally, the best time to find promising small companies is during a lull in the sector, not when it's surging and stock prices are soaring.

With that in mind, The Times ran a computer screen using Market Guide Inc. data that searched for young companies with promising prospects. We turned up 20 names and have profiled five of them below.

The companies operate in a number of industries and the performances of their stocks are just as varied. Some have outdistanced the blue-chip Standard & Poor's 500 stock index in the last 18 months, while others have trailed.

However, they share important traits: all have exceptional sales and earnings records that are projected to continue.

To be included in our list, a company had to have a market capitalization of less than $750 million, the generally accepted definition of a small stock. Many of the companies have far smaller market values.

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We also required that companies show sales and earnings growth of better than 20% annually for each of the last three years. To ensure that the numbers are likely to continue, the companies also had to have expected growth rates in the next three to five years of more than 20% annually.

As for valuation, price-to-earnings ratios on operating profits over the last 12 months had to be less than 40. To be sure, that's a high P/E. But even when small-caps are out of favor, strong companies can carry hefty valuations. And as the list demonstrates, the P/Es of many companies are far less than 40.

We also wanted to see heavy insider holdings, so we required that managers and other insiders own 40% or more of their companies. Extensive insider ownership can be a double-edged sword. In some cases, it lets insiders manage a company with little regard for other shareholders. But more often, a high level of insider holdings spotlights a company that has a huge financial stake in making sure the stock performs.

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Finally, we required that the companies have positive earnings surprises in each of the last four quarters. A positive earnings surprise is no guarantee of future performance. It can be misleading because companies intentionally underplay their prospects so that analysts will set estimates the companies know they can exceed.

Nevertheless, it's far better to have positive surprises than negative ones. Especially in today's climate, where stocks often get pummeled if companies fall even a penny or two shy of estimates, investors want to own companies with track records of making Wall Street happy.

99 Cents Only Stores

A company doesn't have to charge high prices to turn a nice profit.

As its name implies, Commerce-based 99 Cents Only Stores charges but a single price on items ranging from batteries to chocolate bars. Nevertheless, its sales in the last five years have grown at a compound annual rate of 17% and its net income has expanded at twice that clip, according to Deborah Lowenthal, an analyst at Red Chip Review.

The company has succeeded in part because consumers like bargains regardless of how well the economy is doing. And unlike some other bargain retailers, 99 Cents stores are clean, well-lit and attractive, Lowenthal said, features that spur a lot of repeat business.

"99 Cents Stores is doing a good job of getting people to go in there every day," she said. "It's amazing. You say, 'Wow, I'm not embarrassed to shop here. It's bright and clean.' "

The company has 57 stores and management believes Southern California could eventually absorb 200 to 250, Lowenthal said. 99 Cents is opening its first store in San Diego by year-end and might move into Las Vegas, she said.

Central to the company's success is its wholesale unit, which supplies the stores with inexpensive products. The unit buys huge quantities of products at close-outs and also sells to other bargain chains.

In keeping with the nature of its stores, the company is run efficiently and has spartan offices, Lowenthal said.

The company recently completed a secondary offering that increased the number of shares in the public's hands. That could be a positive, Lowenthal said, because it could allow mutual funds, which previously couldn't buy the stock because of its thin liquidity to jump into the stock and push up its price.

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