Nor does the fact that small cap investors have mushroomed from a short list of specialist fund management firms and boutiques to a group that now encompasses small cap portfolios within virtually all the leading institutions as well. Their growing numbers just make the task of identifying the most appropriate targets for any single company more taxing. Nevertheless, the opportunities for telling a small cap story are probably as good as they have ever been. In the following pages, we look at some of the companies, consultants and fund managers who contribute to the dynamism of this sector of the market.
American small caps had a great summer in 1995, with favourable valuations attracting a multitude of new followers. Virtually all major small cap indices reached record highs in recent trading, and the Russell 2000 and Nasdaq Composite, led by the buoyant high tech crowd, were no exceptions.
While some investors may be wondering where small caps can go from here, a PaineWebber analyst specialising in small companies points out that debate over large versus small caps is outmoded; today, the paradigm has shifted to growth versus non-growth. It’s the growth stocks, of course, that are leading the small cap pack, with smaller issues sharing the benefits of a positive environment for stocks that can produce stellar growth despite the backdrop of a rollercoaster economy to contend with.
No wonder, then, that growth stories abound in the small cap arena. Take Glenayre Technologies, perhaps the all-time rising star of Nasdaq and a client of Lippert/ Heilshorn Associates, an investor relations consultant that specialises in emerging growth companies. This high tech company from Charlotte, North Carolina, has seen its stock price go from $33/4 in September 1992 to $651/4 by August 1995 – a 1,700 per cent rise in three years.
Another stock that characterises the small cap phenomenon is Kent Electronics of Houston, Texas. Since signing on with IR consultant Morgen-Walke Associates in 1990, NYSE-listed Kent has gone from $40 mn to $515 mn in market cap, and has just completed a secondary offering of 2 mn shares at $44 1/4 per share.
Meanwhile, some fund managers are uncovering small cap gems in the form of income stocks that stay small but deliver a handsome dividend to shareholders.
Take WD-40 Co, which has been a household name in the US and beyond for 40 years. With just a few employees, a tiny office in San Diego and sales of $112 mn in 1994, the $340.4 mn company is a cash cow, paying a dividend per share of $2.30. It occupies a favoured spot in burgeoning small cap income portfolios, while other candidates for strategic small cap investors are prospective targets in the current M&A boom that is proceeding at a torrid pace.
But whether the story is an M&A play or just good value, the investor relations strategies of small caps are paying off in the fickle 1990s. These stories have been so good in some cases that a small cap has been turned into a large cap virtually overnight. Netscape, a 16-month old Internet software company, had bankers snapping at its heels to get at its August IPO. In the end, lead underwriter Morgan Stanley took first day orders of 100 mn shares, and the stock rocketed from its offering price of $28 a share to $75 a share, taking the company to $2.6 bn in capitalisation – all the more astonishing given the company’s net loss of $1.6 mn in the latest quarter on sales of $12 mn.
Sometimes, however, the hype just doesn’t pay off. Normandy America, a reinsurance firm, yanked its IPO the day after trading began this summer. By then the stock had already dropped to $23 1/4 from its starting price of $25.
Despite the recent rash of small cap successes, the challenge of marketing small caps to the investment community remains no easy task. Sweeping changes on Wall Street have altered the terrain for CFOs of small companies, making it more difficult to target investors.
In the past, certain analysts or boutiques specialised in small caps, while larger institutions and pension funds stuck with the blue-chips. Now even such giants as Fidelity, Calpers, Bankers Trust and Trust Company of the West have established dedicated small cap growth funds, and small caps have to seek out crucial, long-term support by scouring the universe of investors for just the right niche shareholder.
Part of the problem is the myriad of definitions of just what a small cap company is. The criteria used to be five million shares outstanding, or a maximum market capitalisation of $50 mn. Now even the IR consultants cannot agree on a definition. In fact, there are almost as many definitions as there are investors. The Financial Relations Board, the firm that lays claim to being the world’s oldest and largest financial PR company, pegs small caps at between $30 mn and $100 mn in market cap. Below them are the new micro caps; above them the mid-caps, capitalised at up to $500 mn.
Morgen-Walke Associates sees any company of under $500 mn as a small cap. GS Schwartz & Co, a New York-based PR firm, agrees with the $500 mn small cap ceiling, but deems a company below $100 mn to be a micro cap, while pointing out that some so-called small cap investors are looking at companies in the $700 mn range. According to Richard Anderson, executive vice president of GS Schwartz, this inconsistency of view about the definition of small caps exacerbates the difficulty facing their IROs, since it makes it harder to identify those investors whose criteria their companies might meet.
‘Each company has certain characteristics which should appeal to a number of different audiences,’ says Anderson. ‘Rather than attack the whole universe, small caps should do ‘micro-marketing’. For example, an east coast retail chain should begin with T Rowe Price, Vanguard or Legg Mason, whose analysts and money managers are familiar with the region and its economy. You have to dig for these people,’ he adds, noting that potential investors may include the company’s customers.
When establishing IR programmes, Schwartz’s consultants put a lot of weight on media coverage, particularly for micro cap clients. ‘Half the battle is won if a fund manager or analyst recognises the company’s name when an IR pitch reaches his desk,’ Anderson says. ‘We maintain a database of thousands of trade publications, and a big part of our IR effort for small caps is placing stories.’
Ted Pincus, chairman of The Financial Relations Board (FRB), sees great progress in the last ten years in the way small companies get their message across. His firm represents 69 NYSE-listed companies, 187 Nasdaq National Market System companies, and a handful of small caps listed on the Amex or Nasdaq. About half of the clients are small or mid-cap companies.
‘Small cap communication with shareholders has taken quantum leaps in terms of quality of annual reports and annual meeting presentations,’ Pincus says. ‘But progress with analysts and fund managers has been spotty. More small caps should examine their investment appeals and set out an effective corporate profile.’
Some 25 years ago, FRB pioneered such corporate profiles, which take the form of a model research report. Pincus says that his consultants zero in on management’s vision for the future, growth track record and performance goals. The end result details why the company is a solid investment story.
The next step is audience research, and FRB devotes a full third of its workforce to maintaining and communicating with a database of 30,000 investment professionals. ‘We try to identify the specific tastes and habits of analysts on the buy and sell-side,’ Pincus says. ‘Aside from the large 13F institutions, we have identified hundreds of smaller institutions for whom small caps are the perfect vehicle. They’re like a hidden third market for small caps to discover.’
Pincus scoffs at companies that think they have marvellous IR simply because they haven’t had any complaints from stockholders. ‘If there is an IR acid test, it’s whether IR is having an impact on a sustainable PE multiple,’ Pincus says. ‘And the only way to change the PE is with an influx of new investors. Many small caps just churn out press releases and answer the phone. That is simply not enough.’
Lippert/Heilshorn’s offices in New York, San Francisco and Jerusalem service around 60 Nasdaq-listed small and mid-cap companies. ‘Successful companies are those that are possessed with a clear definition of themselves, their competition and how they are differentiated,’ John Heilshorn says. ‘Small caps have to take that message, stay consistent with it, and continually educate the financial market place.’
Heilshorn says that he uses a more focused approach than the larger agencies. ‘A fledgling business should never go after 300 potential customers,’ he says. ‘It should start small and build. For a micro cap, there may be only twelve institutions, three sell-side analysts and a few brokerages which are worth talking to. Media relations works in tandem with this strategy. A good placement is not a panacea for an IR dilemma, but it goes a long way towards opening the eyes and ears of investors.’
Small caps should gear up the investor relations effort at an early point in their lifecycle, according to Heilshorn. ‘It is never too early to massage the image of the company,’ he believes. ‘We like to start working with a client even before the IPO, focusing the message and introducing them to the investment community. Hopefully, the result is an investor feeding frenzy on the scale of Netscape,’ he says.
On the other hand, Heilshorn warns of over-extended IPO hype which creates false investor expectations: ‘A company must make sure the story told to the market by bankers is straight and within their capability to achieve. The secret to IR is saying you will do something, then doing it. If something goes wrong, don’t wait to educate the market. False promises are an anathema to investors.’
Lynn Morgen, founding partner of Morgen-Walke, is also wary of unfounded IPO excitement. ‘A lot of small cap IPOs stumble even in their first quarters out of the box,’ she comments. ‘But those are critical quarters. If management is busy on the road, and the CFO is spending day and night putting the prospectus together, they may not realise what is going on with the company.’
Morgen-Walke has a special understanding of small caps, having grown from an entrepreneurial duo 13 years ago to the second ranked US IR agency, with 100 employees and offices in New York, San Francisco, Dallas, Boston and Toronto. Along the way, many of Morgen-Walke’s small cap clients have become mid-caps, and the firm is now working with large cap companies up to $6 bn in capitalisation.
But the entrepreneur’s mentality is still important to Morgen-Walke. ‘Our whole business is relationships,’ says Morgen. ‘Through research and networking, we have developed one-on-one relationships with hundreds of smaller fund managers who you won’t find looking at books or directories. It’s important to be close to the Street, maintaining an ongoing dialogue with investors.’
In effect, Morgen-Walke’s core strength is making introductions. The firm sponsors dinner meetings with sell-side analysts, and strategic discussions between CEOs and fund managers. Sometimes the firm takes analysts on field trips to client facilities. ‘It’s hard to be a small cap,’ laments Morgen. ‘Many of our clients are growing very quickly, which poses a great challenge. Projections are very difficult to make in high growth industries, and while investors focus on quarter-to-quarter earnings, small caps have to think of the long-term.’
Small caps often learn IR through the school of hard knocks. Carl Thompson, CEO of Carl Thompson Associates, however, together with president and co-founder Shirley Thompson, gives workshops on the techniques and principles of an effective IR programme. They also offer an SEC disclosure workshop for top management at newly public companies to develop disclosure policy, and explain ‘what life in the fishbowl is like – and how to stay out of trouble.’
Thompson earned his IPO expert stripes as vice president of investor relations at Hill & Knowlton’s Denver, Colorado office during the emerging growth boom of the early 1980s. Since starting his own firm some ten years ago, back in 1985, he has led dozens of small cap companies up the capital markets learning curve, but not all his clients are minnows; he also advises such regional blue chips as US West and Coors. As much as 20-30 per cent of some offerings handled by Thompson have wound up in the hands of his firm’s contacts on both coasts.
‘The naivety of a new company is probably our biggest challenge,’ Thompson says. ‘Our role is to educate CEOs and CFOs in the nuances of being a public company, leaving them with a realistic expectation of what IR can and cannot do for them. Reaching a level of capital markets maturity means realising that good investor relations cannot replace company fundamentals – you can’t perfume a pig,’ he adds.
Understanding what investors want to hear when they purchase small caps is critical for any small cap CFO. Nicholas Galluccio, a former Forbes magazine staff-writer and investor in small cap value companies, is just such a case study for small cap IROs. ‘I love buying growth when the stock price falls down,’ says Galluccio, a managing director of Trust Company of the West, a Los Angeles-based fund manager with $50 bn in assets under management. ‘Then the company straightens out its problem, the earnings turn, and, when people believe the earnings turn is real, they confer a growth multiple back on the stock.’
The $1 bn-plus fund that Galluccio manages, along with three other people, specialises in small cap value stocks. The fund comprises 270 companies with a median market cap of $280 mn. Some 85 per cent of the fund is invested in companies below $500 mn in market cap, and 65 per cent in companies under $250 mn. Each holding comprises a small percentage of the portfolio because of the volatile nature of small caps but, despite this, over 40 positions in the fund represent 5 per cent or more of companies’ outstandings shares.
Galluccio stays away from IPOs. ‘They are priced for the benefit of the seller, not the buyer. You never hear negatives on a roadshow, only positives,’ he says. ‘But a company is vulnerable to all kinds of glitches. People who forgot what they bought during the IPO unload the stock, the company gets hit unmercifully, and that is when we step in and do our work.’
When Galluccio goes after an investment, he wants a quick statistical framework from the IR team: the five-year growth rate on sales and earnings; the debt to equity ratio; the book value; the price to book; the market cap to sales ratio; and excess cash on the balance sheet. Then he wants to know the story: Is it an exciting one? How is the business changing? Is there new management or a new product cycle?
Galluccio expects the person responsible for a small cap company’s investor relations to be creative; and they should have asked management all the above questions ahead of time, so that they can explain to people like him what it is that makes their stock interesting. ‘I want to know if it’s a turnaround story, an asset play, or a growth stock,’ says Galluccio, who is turned off if he hears a boring story.
‘Investor relations officers should dig hard and ask incisive questions of management to find the catalyst that will make the stock go up,’ he advises. ‘They must have that special thing that makes the company interesting, while having the financial data at their finger tips. A major weakness in investor relations officers is a lack of understanding of the company they represent. I want bottom-up, fundamental research. I want to kick the tyres, visit company management, and I do thorough due diligence on every company in our portfolio.’
Faced with a universe of hard sells like Galluccio, many small caps may be daunted by the investor relations task. But CFOs and in-house IROs should take heart: a good company makes a good story, and for every good story, there are scores of investors waiting to listen and to act on what they hear. Small cap entrepreneurs are the financial backbone of North America, offering growth, value and sometimes income to investors of all shapes and sizes.
They can probably all take John Heilshorn’s emerging growth motto as their own: ‘Start small and build’.
Evergreen Eyes Entrepreneurs
Stephen Lieber, chairman of Evergreen Asset Management Corp, is oriented toward the entrepreneurial opportunity, which is ‘by nature small cap companies.’ Since starting Evergreen in 1969, Lieber has made his life’s work out of in-depth research into the small, undiscovered corners of corporate America. In fact, original research is the foundation of Evergreen’s small cap success, and its Purchase, New York office houses a library with four full-time librarians keeping track on a universe of 35,000 companies.
Lieber went into the fund business in 1971 with his flagship Evergreen Fund, which is predominantly invested in small caps with around 40 per cent large cap entrepreneurial companies. 1978 saw the start of the first equity income fund, the Evergreen Total Return Fund, while in 1983 the Evergreen Limited Market Fund was launched to concentrate on companies under $100 mn in market cap. All in all, Lieber has developed 17 funds.
Last year, the then $3.6 bn Evergreen family of funds was acquired by First Union National Bank of North Carolina, itself a subsidiary of First Union Corp, one of the ten largest bank holding companies in the US. The Evergreen tag has since been applied to all First Union mutual funds. The Purchase group now oversees over $5 bn in assets under management; the whole First Union group of funds over $10 bn.
‘We mix the value and growth approaches, seeking out growth which may not be apparent to most investors,’ Lieber explains. ‘In some cases, companies that are significantly undervalued or overlooked become an M&A target. Since Evergreen started, some 480 of our companies, or 10 per cent of our portfolio, have been acquired and their value realised – that is the measure of our success in buying undervalued companies.’
Lieber describes Evergreen as academically oriented. Of the 100 employees, 16 are analysts who scan quarterlies, annuals, press releases, magazines and sell-side research in their effort to come up with ideas. They also make regular junkets to visit companies and trade shows. ‘Relationships with the sell-side are not very significant at Evergreen,’ says Lieber. ‘Other managers might value their luncheon meetings and telephone contacts, but Evergreen puts weight on reading.’
Once a pick has been made, however, Lieber makes sure communications are establis ‘We talk to every company, and if there are issues needing clarification, we pay them a visit. Right now, we’re sending an analyst to see a healthcare company in Arkansas to see how they’re manoeuvring through the regulatory quandary. In another case, two Georgia companies merged and we went down to probe their strategy.’
Evergreen tries not to take more than a 5 per cent stake in any company because of the liquidity factor. ‘Sometimes even 5 per cent of a smaller company is not marketable,’ says Lieber. ‘There are many situations where we cannot get out of a stock if we take a very large position.’ Evergreen votes all of its proxies for the companies in its portfolios, with each proxy being reviewed case by case.
With $70 mn under management, the Evergreen Limited Market Fund focuses on some 140 micro caps with a median cap of $46.5 mn. About 90 per cent of the companies in the fund are listed on Nasdaq. Derrick Wenger, Evergreen vice president and manager of the Limited Market Fund, needs all his nerve when tracking his micro caps: these are very illiquid stocks, so staying power and long-term vision are often needed to ride out losses.
‘I look for a proven history of operating earnings, not net income,’ notes Wenger. ‘I like companies that grow and post earnings year after year. In an extreme situation, with a company in a rapidly growing sector, I can make exceptions on the earnings criterion, but I have to see evidence of profitability. I also look for a competitive advantage – a great product, niche domination. Finally, I like to see strong insider ownership, and I don’t like over-leveraged companies.’
As for IPOs, though Wenger looks at a lot, many don’t have the financial history he needs to make his evaluation. ‘In an IPO, there are expectations based on what a company says it is going to do,’ Wenger says. ‘But when they miss their projections, I have to look at the reasons and weigh those against the investment. The sucker game of the day are funds who say they have companies which will have positive surprises. These funds are obvious targets for manipulative management who continually understate earnings. I am wary of such manipulation.’
Small caps are traditionally capital short, and therefore unlikely to pay a dividend. However, the new Evergreen Small Cap Equity Income Fund looks for the exception. With a maximum cap of $300 mn and a median of 187 mn, the young fund is still only $4.9 mn in size. Lieber admits the name of the fund is almost an oxymoron. ‘But there happen to be lots of small caps that are either rich or that barely need capital,’ says Lieber. ‘We have seen such companies, even with strong growth trends, paying out the bulk of their earnings in big dividends, and we have found a wonderful growth opportunity.’
Mylex Corp: IR Scores Results
In early 1994, Mylex Corporation, a small cap high tech company from California, came to John Heilshorn of Lippert/Heilshorn Associates with a great story: and for sure the future looked bright; but the company’s track record was dismal.
Since 1990, the computer motherboard maker’s stock had hit a low of $13/16 and a high of $71/2. Trading volume over the three years averaged 100,000 shares a day. Erratic earnings had put the company in the capital market’s bad books. But Al Montross, Mylex’s new president and CEO, was ready to launch a turnaround. Mylex was on the verge of achieving profitability, and Montross intended to make sure the company delivered a strong earnings performance. In short, Mylex had all the makings for a proactive financial communications programme.
On March 1, 1994, Mylex’s stock closed on Nasdaq at $51/2 with just 17,500 shares traded. Within three months, the company was ready to take its story to new investors. Lippert/Heilshorn Associates helped in developing management’s presentation, preparing a fact sheet and studying the market place’s level of interest in the company. Mylex launched its roadshow in Boston in July of 1994, and visited six more cities in six months (see chart).
The roadshows certainly paid off. Montross made sure Mylex achieved its promised profitability in the second quarter, secured major contracts, expanded its product offering, and increased earnings per share by 40 per cent in the third quarter. With promises met and targeted meetings relaying Mylex’s success to analysts and institutions, the company’s stock price and volume took off. Over the six months, the company saw its stock price more than double to $81/8 (see chart). And the same period brought new analyst coverage from Utendahl and Cruttenden Roth.
From February to August 1995, Mylex hit the road for another six-month stint, and saw its stock price double again to $161/2 by August 8. It also reported strong earnings and announced major agreements with Fujitsu, Intel and Xpoint. Analyst coverage was expanded again, with Crowell Weedon, Rodman & Renshaw, Madison Securities and First Albany all starting to follow the stock.
‘The endorsement of additional analysts at this stage is very important to small caps like Mylex,’ comments Heilshorn. ‘Small caps shouldn’t go after a Merrill Lynch for coverage but should concentrate on an analyst from a tier firm that fits with their personality. Most of the small boutiques have special situation analysts looking for undervalued companies.’
All in all, Mylex stock quadrupled since it launched its investor relations effort, and trading volume increased by an average of 200,000 shares a day. The company recently closed a secondary offering of 2 mn shares with Needham & Co, a medium-sized investment boutique focusing on medical and high tech companies. Priced at $171/2, the new offering promises to enhance Mylex stock’s liquidity for institutional holders, while providing working capital to continue building the company.
‘The key to the Mylex story was achieving its corporate objectives,’ adds Heilshorn. ‘Thus we had a good story to tell, and we were instrumental in getting Mylex the investor attention it deserved. It was a top-to-bottom story, and a well crafted one. The strength of management’s contacts and communication skills were also reflected in the turnaround.’
Ten Commandments for Keeping Your Company out of Trouble with the SEC
| I | Thou shalt not have strange securities before the marketplace. |
| II | Thou shalt offer securities only through the prospectus and shalt not jump the gun or precondition the market. |
| III | Thou shalt not use knowledge gained from inside a corporation to make a better deal than those outside the corporation or thou shalt be known as an insider and subject to wrath from the SEC and class action lawsuits. |
| IV | Thou shalt not honour thy father and thy mother – or others – with knowledge gained as an insider, making them tippees and subject of scorn. |
| V | Thou shalt not tell all of the people some of the time and tell some of the people all of the time; thou must tell all of the people all of the time. |
| VI | Thou shalt not blab information about earnings or other material things to any more people than necessary within the company or among thy counsellors. And thou shalt not blab any of these matters to any others. |
| VII | Thou shalt not hold material information for leisurely distribution, but thou shalt make immediate and broad dissemination. If thou cannot decide whether or not information is material, thou shalt consult thy attorney. |
| VIII | Thou shalt not bear false witness when making projections, and thou shalt not make projections based more on hope and desire than on fact. |
| IX | Thou shalt not acquire more than 5 per cent of the stock of another company without informing the SEC, although thou art allowed to covet more than 5 per cent without reporting it. |
| X | Thou shalt not commit adulteration on the figures, except on per-share figures where you may adulterate like mad to reflect overhanging options and convertibles. |
