Small caps to lead out of the economic "rubble"

Jennifer Schonberger | May 28, 2008 10:40am EDT | Comment

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After what seemed to be an ephemeral spring rally, stocks were pummeled last week with oil’s skyward climb, the Fed’s bleak outlook and unwelcoming economic data. However, once the credit kinks are worked out and the dust clears, small caps may be the place to park your money, according to Bill Greiner, chief investment officer for UMB Asset Management and UMB Bank, and chief economist for Scout Investment Advisors.

“There are a number of factors that have led me to believe that small-cap equities will probably do well going forward — and those factors center on how bad things are right now,” Greiner said in an interview with SmallCapInvestor.com.

Greiner points to economic indicators for signs of probable future success for small caps. First he examines consumer sentiment. According to the veteran investor, when you analyze the consumer sentiment data, you look at the trend over the last 30-year period. When the read on consumer sentiment has been below a level of 96, the following 12-month period of time small-cap companies have outperformed large cap companies by close to 1,000 basis points, Greiner said. The latest read on the consumer confidence index was below 76.

“When the consumer’s been this negative before, it’s been a great time to buy small-cap companies,” he said.

Next, Greiner looks at economic coincident indicators, a coincident economic indicator is one that moves at the same time the economy does. The latest read for coincident economic indicators overall was 0.56%.

“The last time we were in this environment was back in the early 2000’s, right before the start of the big rally in stocks in general,” said Greiner. “That leads me to believe that small-cap companies are probably positioned relatively well.”

According to Greiner, when coincident indicators have been at this stage historically, small-cap stocks on average generated returns of 25.6% for the next 12-month period compared with large-cap stocks that generated returns of 13.8%.

“We’re setting ourselves up right now at least for a six- to 12-month move to where small-cap companies very well may start to outperform large-cap companies based strictly on historical information that I’m looking at,” he said.

When screening for small caps, Greiner says he looks for high-quality balance sheets and positive cash flow that’s sustainable and growing. He looks for companies with market caps in the range of $800 million to $2.5 billion.

“Basically what we’re looking for are companies that can finance their own growth rates,” said Greiner. “By definition, small-cap companies tend to be big capital users instead of capital generators — we’re looking for small cap companies that are capital generators.”

Among small-cap companies Greiner favors include, Hornbeck Offshore Services Inc. (NYSE:HOS) and Woodward Governor (Nasdaq:WGOV).

Hornbeck, which owns 57 offshore oil-drilling rigs and oil-drilling ships, leases its equipment to the offshore oil and gas exploration and production industry. According to Greiner, historically, the company entered into contracts of shorter duration, typically anywhere from a month to a year long. This strategy has boded well for the company as oil prices have climbed and contracts have turned over quickly to capitalize on that.

However, as oil may be topping — at least temporarily — according to Greiner, Hornbeck is beginning to secure longer-term contracts up to six years in duration to lock in lofty crude oil prices.

“What that does with Hornbeck is solidifies their revenue, earnings and cash flow growth rates over the next four to five years,” Greiner said. “The visibility’s becoming much clearer and much less dependent on the actual price of crude. That’s a name that we feel has some legs to it even if oil prices start to roll over.”

Woodward Governor makes turbine blades and systems and is involved in turbine generation fuel systems and power systems. Power generation systems comprise more than half of Woodward’s business.

“That theme of international power generation we think has got some real legs to it,” he said. “Even during a time when growth rates are contracting, many people are still going to spend money on power generation systems because it takes years for these systems to be developed and built.”

Greiner said he expects earnings to increase 30% this year and in the mid-to-high teens range next year.