The Case for Small Caps

When you hear pretty much every investor and analyst saying the same thing, it's usually time to get worried. Of late, stock market pundits have advised investors to bail out of small company stocks and move their chips to the shares of large concerns -- and the bluer the chip, the better. Small capitalization stocks, the reasoning goes, have outrun large cap shares for a long stretch and thus are due for a nasty correction, especially in a slowing economy with rising interest rates.

Doug Pyle takes a different view. As co-manager of Excelsior Small Cap fund (symbol UMLCX), you'd expect Pyle to extol the merits of investing in small-cap stocks -- which he does. But he's worth hearing out: Pyle's record of 11% annualized growth over five years and 17% over three years is outstanding, and he makes some good points.

Pyle notes that in the second quarter of 2006, the relative earnings strength of small companies continued to improve dramatically compared with the numbers for big companies. Hedge funds and private equity, two fast-expanding sources of capital, are increasingly buying small-cap companies or taking major stakes and shaking up managements. And Pyle sees smaller companies as more nimble and better able to adjust in periods of economic change, such as today, than are big, lumbering corporate giants. But even if you're not convinced about relative performance, he thinks most investors should still keep 10% to 15% of their portfolios in small-company stocks.

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How does Pyle pick stocks? He particularly likes stocks that are selling at low prices relative to normalized earnings -- that is, earnings adjusted for the cyclical ups and downs of the economy. Pyle focuses on normalized earnings over the past five or ten years as much or more than on future earnings forecasts. This approach may lead him, for example, to stocks that have been beaten down temporarily because of scandal or market emotion. He favors companies with returns on equity (a measure of profitability) of 15% or higher, low debt levels and upside stock-price potential of at least 25% to 30%. He typically holds stocks for two and a half to three years -- that is a relatively low turnover rate by mutual fund industry standards -- and runs a fairly concentrated portfolio with just 35 to 40 names. "I don't want to dilute my best ideas," he says.

Pyle currently has 35% of the fund in technology shares, his highest proportion ever. After massive industry overinvestment in tech and telecoms in the late 1990s, Pyle says, there's been a severe inventory correction the past six years. Many companies have gone bust or merged, leaving stronger, more cash-rich survivors. Moreover, he thinks capital spending on technology will advance smartly for the rest of this year and in 2007.

One of Pyle's top ten holdings is Commscope, the largest maker of coaxial cables, the "last mile" connection to cable households. His largest position is in Forrester Research, a leading technology-research outfit. Outside the tech arena, his largest holdings include Sotheby's, the auction giant, which he purchased after the stock was crushed by a price-fixing scandal; Kansas City Southern, which he dubs "NAFTA Rail" for its train network extending from Mexico to Canada; and niche insurer Philadelphia Consolidated Holding, a long-held, steady performer.