Tom O'Halloran's favorite small-cap stocks

Jennifer Schonberger | Jul 25, 2008 9:17am EDT | Comment

Rating: Unrated [rate it]

Tom O’Halloran is a partner and director of Small Cap Growth Investments at Lord Abbett. He is responsible for managing the firm’s small-cap and micro-cap growth products, overseeing the investment teams, and directing the investment strategies.

O’Halloran has been in the investment business for 20 years. Prior to joining Lord Abbett, O’Halloran was an executive director and senior research analyst at Dillon Read/UBS Warburg from 1988 to 2001. Before beginning his career in the financial services industry, he was a trial lawyer from 1980 to 1986. O’Halloran earned an MBA from Columbia University, a JD from Boston College and an AB from Bowdoin College. He also is a holder of the Chartered Financial Analyst designation.

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

“There are 3,000 stocks that we look at that we could own. We try to screen out 80% of those through growth hurdles and size parameters in terms of market cap, and financial strength in terms of debt-to-asset ratios. Then we look at the 600 or so, or 20%, of the names. The first inquiry is a two step process after that. First we identify the best businesses then we pick stocks based purely on their growth, not on takeover potential, turnaround potential or valuations. Organic growth is the best kind of growth, but if there’s a strategy of acquisitions that is multi year and sensible to supplement their organic growth, then that’s fine. We require 12% minimum top-line growth, and we want earnings to be growing at least as fast. Our portfolio on average is growing closer to 25%.

“In terms of what represents a good business, we’re looking at four things: the first two at the microeconomic level, or inside the doors of the company, and three and four are considering the environment in which they function.

1) “When we saw Morningstar at $750 million on the IPO, we said, ‘This is like Moody’s. Moody’s is $20 billion. This is a jewel of a business.” We saw Mercadolibre, Inc. (Nasdaq:MELI) at $1 billion and we said, “This is the eBay of South America. This is a great business.’

2) “Is it a good business? Does it have a strong management team? Is the management competent and credible? It’s very important at the small-cap level to have good management. [In terms of] competency, we look at Mickey Drexler at J. Crew. He worked magic at The Gap. He redefined casual clothing in America. He’s a genius of a retailing executive and an example of a highly competent executive. When we think of credibility, we think of Rob Silverman of Strayer. No nonsense, high integrity guy, the only manager to get his company through the regulatory witch-hunt of private education companies at the beginning of the decades. In essence, competent and credible executives and a good business model at the micro level.

3) “Step outside the doors of the company and look at it in its environment. If we want to own the companies that are going from small to mid cap to large cap, we’re going to want to own the best company in the industry. The best company is one that founds and dominates its industry such as Concur (Nadaq:CNQR) in travel and expense management over the Internet. We’re fine with a company that’s gaining increased market share such as Strayer. We want a company with a competitive advantage.

4) We want strong industry conditions. Hostile industry conditions can make a good company look bad. Toll Brothers, for example, is a good company. It looks like a bad company now, though, because the home building industry is in a severe downturn. We want industry conditions to be favorable.

“Looking from a portfolio perspective, it’s important to have a portfolio with diversification and liquidity that enables us to have gain impact from the names. A portfolio of about 120 names is more optimal than one of 300 names. We pick that portfolio based upon the growth characteristics of the company. Faster is better than slower. We look at the rate of change of growth. A company going from 8% to 17% such as TeleTech can triple in value. Whereas a company going from 150% growth down to 40% growth such as Crocs can get cut down to a third of its original value, so acceleration and deceleration is very important to consider.

“Then lastly, expectations. We need to have a keen sense of what the market expects of the stocks and to believe that the stocks can deliver as well as expected or hopefully better than expected.”

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

“There are two education stocks that have market caps under $1 billion that I think are very attractive. American Public Education (Nasdaq:APEI) provides online education to the military. What’s exciting about it is not only has it had a great track record of growth, but it’s now recently gotten wider accreditation from the Navy. Its business with the Navy will be expanding. More importantly, it’s expanding into the civilian workforce, so fire departments, police officers and other sectors like that.

“The other one that we find attractive in the same sector of education is K12 (NYSE:LRN), which provides online education for grades K through 12 for kids that are home schooled. The teachers for the online education course setting are all accredited.

“We feel that this is an emerging segment of the education industry that is growing very fast. K12 is growing 55% this year in revenues and American Public Education is expected to grow 50%. These companies are expected to have 50% revenue growth in an economy that’s experiencing 0% growth. They look very attractive.

“RBC Bearings (Nasdaq:ROLL) has had a very good business with precision bearings that are used in a wide range of industrial products. Now RBC plans to enter the wind turbine business supplying bearings it uses on these turbines. This will be a big growth catalyst for the company going forward. This year the company will probably grow its top line about 12% and will either maintain that growth for a long period of time or accelerate, as wind becomes a bigger part of the business. It grew its earnings 20%, so the profits are growing somewhat faster than the earnings.

“Then there are names I follow that are very beaten down. In technology, Aruba Networks (Nasdaq:ARUN) is down to $5.70 from $24. It provides mobility solutions. Normally when one uses the corporate computer for a company, one has to go through a firewall. The company’s technology assigns a unique identification to the user, so one doesn’t have to go through a firewall, therefore much faster connectivity is enabled for mobile workers. This stock is venture-capital backed by Sequoia Capital, which is one of the best venture capital firms. The management is strong and it’s a company with great promise.

“Another one is EnerNoc (Nasdaq:ENOC), which provides network operating centers [for utilities]. EnerNoc is a company that is growing its sales. It grew at a triple-digit rate last year and this year it’s expected to grow 70%. It grew revenue 80% in the first quarter. EnerNoc just signed a contract with the Tennessee Valley Authority to provide demand response capacity. The TVA, this could be huge.

“This stock has corrected from $50 down to $9, now it’s at $18, so there are some great opportunities. The fear that these companies will be hurt by this economic slowdown has created some great values.

“Colfax (NYSE:CFX) is another name we like a lot that has recently gone public. It went public at $18 and now it’s at $24. It’s got a $1.1 billion in market cap, so right on the cusp.

“It makes fluid handling equipment that is used in big infrastructure projects and was founded by the founders of Danaher (NYSE:DHR), which is a $25 billion public company. We know it’s got good people and good processes for running the business. We think this is a company that is going to exhibit superior growth for the next three to five years. We think over that timeframe, it can outperform the market from these levels.”

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

“We would like to be holders of the companies for three to five years. We look for companies that can move to a mid- and large-cap status within one to seven years. Often times, the holding period can be shorter because the bull markets of these stocks probably average about 18 months.”