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Small-Cap Dynamics Editor’s Note: Today, we have a very special Sleuth. We were able to get an excerpt from Satya Dev Pradhuman’s Small-Cap Dynamics: Insights, Analysis, and Models. Pradhuman is CEO of Cirrus Research and former director of small-cap research at Merrill Lynch. This book is the “essential handbook” for all small-cap investors — small or large. In this excerpt, he discusses the three types of small-cap evolution, along with two classic examples…
Small stock investments typically take one of three shapes. A rising star is a growth stock that evolves from a microcap to a megacap status, seemingly overnight. Another type of small stock is the fallen angel. Like Icarus, who, in Greek mythology, soared too close to the sun and fell because his wings melted, hyperactive growth can lead to disastrous missteps, which can cause a fall from grace. Small stocks that fall from the large-cap arena into the small or even the microcap world could be considered “damaged goods.” The third path of a small stock can be like the rise of the phoenix from ashes. It is a resurgent fallen angel or a stock into which market participants have priced too much risk. All investors want to partake in the first and third stages and avoid at all costs, buying into a falling angel. At one time or another, all stocks fall into one, two, or even all three of these categories. One can reasonably argue that Oxford Health Plans, the health management organization, has, fortunately and unfortunately, moved through each of the three stages identified — it has been a rising star, a falling angel, and, possibly, a rebounding fallen angel. Cisco Systems, the networking hardware giant, could be seen as a rising star that gained megacap status in just seven years. Cisco has managed to step away from significant threats and nimbly avoid the second stage that rapidly growing companies can encounter. Detailed analyses of these two companies follow. Oxford Health Plans A managed care organization that embodied the hopes for a market-based solution to rein in health care costs, this start-up was founded in 1984 and successfully grew into one of the most profitable health management organizations (HMOs). Oxford Health Plans (OXHP) went public in 1991 at $45 million market capitalization and quickly issued an additional 30 million shares, pushing its capitalization to roughly $136 million by September 1991. The stock then rapidly became a star performer by gaining more than 68 percent in market capitalization in just 12 months (see Figure 1.2). The demand of the market for accelerating growth stocks may have encouraged a more rapid expansion than was foreseen in Oxford’s original game plan. The firm had entered the Medicaid and Medicare markets by 1992 and introduced additional plans to broaden its customer base. Aggressive acquisitions in other related fields and regional markets allowed the company to deliver exceptional growth. The stock raced to new highs; by 1993, its market capitalization had shot up to more than $1 billion. Oxford became a midcap stock by late 1994. Unfortunately, as companies gain growth momentum and become more sizable, the path to continued success becomes narrower. Oxford became a victim of its success. The rapid growth from which it benefited also made it very difficult to keep tight controls on internal systems. This fault became terribly relevant as expenses in the industry began to rise. Investors then became quite concerned and, in a single October day in 1997, Oxford lost 62 percent of its market value. The stock continued to collapse in the subsequent year. From a high of over $6.5 billion, it fell to a mere $500 million by August 1998. In one fleeting year, a very large and successful firm with almost a blue-chip presence fell back into the small-cap market. The company has since attempted to stem the collapse by cutting costs, focusing on core businesses, and placing better internal financial and accounting controls. The stock has rebounded nicely; it almost doubled to over $1 billion by November 1999. For a second time, Oxford has been able to quickly double in size as a small-cap stock. This time, however, its path was not completely new. Cisco Systems Cisco Systems (CSCO), the data networking equipment company, is the classic Silicon Valley small-cap success story. The growth of this company lies in its uncanny ability to strategically focus itself on the changing demands of the data networking business. Cisco went public in 1990 with roughly $139 million in market capitalization. The stock subsequently jumped almost one hundredfold in nine years. Cisco became known for its industrial-strength router equipment. Routers allow separate computing networks to interoperate by sharing data and functionality. With networking traffic beginning to accelerate with the rise of corporate interactivity and the profound increase of e-mail traffic in the late 1980s and early 1990s, Cisco became the dominant player in the router market (see Figure 1.3). In three years, Cisco had grown more than fourteenfold. With the dramatic increase in the usage of network-based computing, Cisco recognized the need for additional solutions. The company smartly recognized that LAN (local area network) switches were desperately needed to alleviate network congestion. LAN switches allow traffic on a data network to be rerouted to underutilized links. Not being a player in the LAN switching business, Cisco aggressively used its highly valued stock to acquire three key players and enter this market. By 1997, Cisco had captured a dominant market share in the switching business. Since that first acquisition in 1993, technology companies, including Microsoft, Intel, and Oracle, took notice and also began using their rich stock to wield significant influence in the marketplace. By 1999, Cisco had made several acquisitions and entered into joint ventures to tap into the rapidly growing wireless and Internet market. Cisco has made nearly 30 acquisitions in a mere six years. By 1999, Cisco’s capitalization had reached over $200 billion. Is Cisco the next Microsoft? It is certainly off to a good start. Cisco might be considered a best-case scenario for investors. The stock became recognized, even as a small cap, in a fairly quick fashion, and the investors were rewarded. Cisco is rare because it has been unwavering as a large-cap stock. The company has been quite able to focus on, predict, and satisfy new demands in a rapidly changing technology market. Small-Cap Cycles Tend to Be Severe The rapid growth of the Ciscos and Oxfords of the world not only reflected individual success stories, but also was part of a greater rebound of the entire small-cap market in the early 1990s — a rebound that illustrated the type of compelling returns this market can generate. After lagging the large-cap market for seven years, small caps bounded back to the forefront of market attention. The Russell 2000 small-cap index jumped 58.6 percent from the bottom of the cycle in October 1990 to the following year. Small-cap stocks jumped 28.2 percent annually for a gross of 119.7 percent over the entire cycle. Large companies also fared well during this period, but severely lagged the smaller-company market. At least 10 small-cap funds generated returns well over 60 percent during the course of that rebound period. In the 1970s, the small-cap market had displayed a similar superior performance on a much more extended basis. The small-cap bull market of the 1970s lasted for approximately a full decade. Small stocks generated an astounding 19.4 percent on an annualized basis. By contrast, the blue-chip sector posted a paltry 8.5 percent in this same time frame. Along the way, small-cap fans have also taken their share of lumps. The latter half of the 1990s perhaps represents one of the most painful chapters in small-cap history. During this time, the global investment village became entranced with mega-size global franchises. Incredible sums of money were diverted from all over the world to capture some of the wealth promised by these titan-size corporations. As a result, the large-cap blue-chip franchises posted spectacular results between 1994 and 1999. In a five-year period, large companies gained a whopping 187 percent, or 23.5 percent annually. Even though small-cap returns were favorable, they posted an annual gain of only 13.9 percent. They lagged the blue-chip sector by a sizable 10 percent annually. Smaller stocks also turned in paltry gains during the 1980s. The fledgling group lagged the large-cap sector as cheap large companies flourished in the then-ensuing disinflationary environment. Between 1983 and 1990, large-cap shares outperformed smaller companies by more than 5.0 percent each year. The long-term performance figures support the existence of a premium for smaller stocks; conversely, the small caps’ periods of underperformance can suggest that a bias toward smaller companies is misguided. Yet it is difficult to accept the contrary argument for large caps — specifically, that safer assets are accompanied by higher expected returns. Ultimately, smaller companies have to carry a higher expected return simply because they are riskier assets. Unless the market is terribly inefficient, the small-stock premium is real. If the outperformance of small stocks over the long term were indeed ephemeral, then small stocks would be unable to come public. Investors would shun this asset class and turn to companies that are indeed likely to generate superior returns.
Editor’s Note: As you can see, these three stages in a small cap’s lifetime are very real. Pradhuman goes on to describe various cycles that can explain what we are seeing in today’s market. For a copy of this essential small-cap “handbook,” you can click here and find out for yourself how important this book is… On a different note, to get Gunner and my latest picks for Penny Stock Fortunes, you’ll have to get in now… We just wrapped up our February issue and should be sending it out to our readers later this week. The first company is one of the best alternative energy plays I’ve seen in a long time. The second is a unique risk-free company strategically placed in the semiconductor industry. There’s even a niche, speculative play on the recent energy act. To check these companies out before they go gangbusters, click here… |
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