Friday, November 15, 2002

In Search Of Small Stocks

Boosters of small capitalization stocks have had many of their arguments stripped from them in 2002. Weakness in both corporate earnings and the overall economy suggests that small caps aren't primed to lead, as they have historically done in past recoveries. What's more, with the downturn in the broader market over the last year, the valuation gap between large and small stocks has narrowed considerably.

So what's the case for small stocks now? Transparency, says Todd McCallister, manager of the USAA Small Cap Stock Fund ( USCAX) . "They don't tend to have as many special-purpose entities or off-balance-sheet financing," he suggests. "You can figure out what's going on easier."

An economist by training, McCallister explains that market position is his most important consideration when making a stock pick. "We look for companies with limited competition or a barrier to entry," he says. McCallister argues that companies with a high return on equity (net income divided by book value) often enjoy a good market position and the ability to finance themselves rather than having to issue new bonds or equity.

Example: Scientific Games, a provider of technology systems and services for instant ticket lotteries (as opposed to traditional statewide lotteries) and racetracks. With a 65% share of both markets, the $394 million (market value) company meets McCallister's requirement of being an industry leader.

As the contracts for both its lottery and racetrack businesses are set up on a multiyear basis, Scientific Games also pulls in steady excess cash flow (cash from operations less capital expenditures and dividends paid), which amounts to $21 million for the latest 12 months.

At a recent $7, Scientific Games sell for 29 times latest 12-month earnings. That steep multiple doesn't bother McCallister; he argues that a low P/E isn't always a good sign when it comes to small cap investing. Reason: A low multiple is often a flag for a cyclical business, a risky bet in McCallister's view.

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