Jim Oberweis' favorite small-cap stocks

Jennifer Schonberger | Jul 24, 2008 9:19am EDT | Comment

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Jim Oberweis is president and lead portfolio manager of Oberweis Asset Management and president of The Oberweis Funds. Oberweis Asset Management, Inc. is a growth equity investment management firm that manages approximately $1.5 billion in micro, small, and small/mid capitalization growth strategies globally, primarily for institutional investors and its own proprietary mutual fund family. Oberweis is a Chartered Financial Analyst. He earned an MBA with high honors from the University of Chicago and a B.S. in Computer Science from the University of Illinois.

What qualities do you look for in a small-cap stock? Have your criterion changed given the current macro environment?

“We look for companies that are growing at very rapid rates and are doing so by creating new products that are innovative a way that no one has been in the past. Our favorite type of company is one that comes in with a new product or service and is able to either create a new market or create significant market share by winning market share from competitors. We like industries where there’s the ability to integrate a set of new providers of services.

“We’re generally looking for a minimum growth rate of 30% annually. In many cases we’re looking for growth rates much faster than that. The average company in our portfolio is probably growing faster than 50% a year. You can understand why a 200- or 300-basis-point change doesn’t have as much impact on a company that’s growing 50% a year. Those companies are doing something different and not just trying to grow earnings at a rate commensurate to the overall economic environment.

“We pay a lot of attention to valuation. If we can buy companies with those high growth rates during periods in which nobody loves them and valuations are sharply below their historical norms, that is a terrific opportunity. Few people actually do it because usually the times when valuations are lowest are falling periods in which the area has reentered the form without marketplace. It’s those times when few people are looking for small-cap growth stocks and often times when your economic opportunity is most variable.”

What are your three favorite small-cap stocks for the year with market caps of under $1 billion and why?

“In terms of specific ideas in technology, I continue to like NetLogic Microsystems Inc. (Nasdaq:NETL). NetLogic is a company that designs so-called knowledge-based processes. These are chips that are used in advanced networks to optimize routing. For example, suppose you had a complicated network that delivers Internet-based television, Voice Over IP telephone, as well as your email and Internet usage. And suppose the traffic on that network was reaching the limits of the bandwidth. You would have to somehow prioritize traffic. If you’re talking on a Voice Over IP telephone and your traffic packet gets delayed and your sentence gets interrupted while you’re speaking, it’s going to be a real annoyance very quickly. On the other hand, if you have to wait an extra 1.5 seconds to receive an email, it’s probably not going to be a big deal to you.

“NetLogic’s chips help networks make that determination on which traffic has to come first. Its first-quarter revenues are up 36% to about $34 million and earnings year over year showed a gain of about 58%, which was ahead of expectations. NetLogic trades at 18 times earnings and we think that if they continue to grow 30%, then that’s going to work out to be pretty attractive.

“eResearch Technology (Nasdaq:ERES) offers clinical trial management software for cardiac research. For example, eResearch software is used to record electrocardiographic results digitally and supply the data back to pharmaceutical companies and clinical research organizations to study the efficacy of treatments.

“Last quarter its revenues were up about 60%, earnings were $0.11 versus $0.04 in the year prior. This has been a growth company for the last three or four years. Its earning margins are in the high teens and its stock is trading at a reasonable valuation in relation to the growth rate.

“Other names I think being overlooked are companies such as VisionChina Media (Nasdaq:VISN), which is a Beijing-based operator of an advertising network that has 39,000 digital TV displays, which are placed on buses and subway platforms in 16 cities in China.

“VisionChina will be a beneficiary of the Olympics primarily because advertising rates are expected to surge as we go through the Olympics. That said, I don’t think that’s a reason to buy the stock. A reason to buy the stock is because it has a great franchise of virtually monopolistic exclusivity that advertises on buses throughout many cities in China. There is typically one single license for wireless broadcast that is afforded to every city in China, so in order to secure a long-term contract, [VisionChina is] the only game in town that is permitted to do this.

“With that license it is securing long-term contracts, and some of those contracts are for 10 years, but some are as long as 50 years where essentially the cost to Vision is fixed, but the advertising rates are likely to be variable. My guess is that over the next 20 years the advertising rates within China are likely to increase, consistent with the growth in the middle class within the VisionChina market place.

“VisionChina has come down in valuation, but it’s had a terrific year overall so far. The stock is up about 85% so far this year, but it’s down from a high of roughly $23. The stock is down for no particular reason that we can find. I just met with management not long ago. I think it’s probably one of my favorite names right now anywhere in the world.”

What’s your typical investment time horizon when you’re investing?

“Typically, a five- to 10-year horizon. Structuring my own business, I’m looking at a 20-year horizon. We try to make a long-term correct investment that doesn’t take advantage of a six-month or a three-month anomaly.

“Internationally, 20 or 30 years — a very long period of time. When we buy a company we look at an infinite investment horizon because the market is going to take a long-term approach and provide that valuation as well. If we try to invest in China or India for a two- to three-year horizon, it can be a gamble. At a minimum, one needs to wait five to 10 years and hopefully a bit longer than that.”