It’s a Small Cap World (for Now) – Russell 2000 Index Up nearly 18 Percent for Year

Graphic courtesy of Russell Investments

 

The stock market finally “took a breather” on Monday of this week, as the Wall Street Journal characterized it. The resilient bull market of 2013 has seen only four sessions in May that had a decline in the Standard & Poor’s 500-stock index and Monday was one of them. This year’s bull market rally has recently been across the board–Asian markets have been up, European markets turned up, and market watchers are anxiously waiting for tomorrow, Wednesday, May 22, when Federal Reserve Chairman Ben Bernanke is scheduled to testify to Congress and the Fed releases the minutes from its last public policy-setting meeting. Will Bernanke offer up any clues about his next steps?

Most importantly for Smallcap World, the Russell 2000 index, which tracks the performance of smallcap U.S. equities, climbed above the 1,000 level for the first time Monday, a metric that MarketWatch considers “psychologically important” for smallcap stocks. As of Monday morning, May 20, the Russell 2000 was up 17.9 percent for the year-to-date, according to FactSet (The Associated Press reported the Russell 2000 up 17.5 percent for the year).

The conventional wisdom is that small caps stock are doing well because they are more U.S. focused than the large caps, which tend to be multi-national. And the U.S. economy is recovering as opposed to other economies around the world. But many large caps are doing well, too,

You don’t have to look far to find small cap stocks at 52-week highs, even “all time highs.” Of course the question always is, how much higher can these stocks go? Buy now or wait for the correction that so many experts have been predicting is right around the corner for months now?

We’ve selected a few stocks we know are at all-time or 52-week highs, and others we’ve covered lately that seem to be on the upswing.

Calabasas, CA-based National Technical Systems * (Nasdaq: NTSC, http://www.nts.com/) is a relatively unknown smallcap stock but also the world’s largest independent engineering services and testing company. It’s biggest markets include aerospace and defense, but also works in the automotive and telecommunications markets, among others. NTSC closed at an all-time high of $13.09, up 94 cents on May 21, with a market cap now of about $150 million. NTSC is lightly traded, only about 7,500 shares a day, although that is trending up. 

Northville, MI-based Gentherm * Incorporated (Nasdaq: THRM, http://www.gentherm.com/) is a global developer and marketer of thermal management technologies for a broad range of heating and cooling and temperature control technologies. Best known for its Climate Control Seat systems that actively heat and cool seats in more than 50 vehicles made by the world’s leading automobile manufacturers, Gentherm (formerly called Amerigon) has branched out into heated and cooled bedding systems, cupholders, storage bins and office chairs. THRM also reached a 52-week high of more than $18 this week, then closed May 20 at $17.78, down 33 cents for the day. Its market cap is now $594 million. As recently as last July THRM was trading at just above $10.

We recently featured Cincinnati-based LSI Industries (Nasdaq: LYTS, http://www.lsi-industries.com/) , a company that offers a different take on an LED lighting company. LYTS creates LED video screens and LED specialty lighting for sports stadiums and arenas, digital billboards and entertainment companies. It closed April 29 at $7.09 with a market cap of $170 million. LYTS closed May 21 at $8, up 1 cent for the day, with a market cap now of $192 million.

Analysts at CRT Capital recently upgraded Atlanta-based Beazer Homes USA (NYSE: BZH, http://www.beazer.com/), a company that builds and sells single-family and multiple-family homes in 16 states in the U.S., to a “Buy” with a $29 price target. BZH also acquires, improves and rents homes. The company operates through commissioned home sales counselors and independent brokers. As recently as last Sept. 14 BZH was trading for $3.77. It closed March 20 at $16.86 with a market cap of $410 million. BZH closed May 21 at $21.75, down 98 cents for the day. Its market cap is now $538 million.

San Jose, CA-based SunPower Corp. (Nasdaq: SPWR, http://www.sunpowercorp.com/), like many solar stocks, have been on the upswing lately. SPWR closed May 8 at $15.36, down 6 cents for the day, with a market cap of $1.8 billion. It closed May 21 at $21, down $1.70 for the day but got up to $23.76 just last week. Its 52-week trading range is now $3.71-$23.76.

Fremont, CA-based Procera Networks (Nasdaq: PKT, http://www.proceranetworks.com/) works with mobile and broadband network operators providing intelligent policy enforcement solutions for managing private networks. PKT’s products are sold under the PacketLogic brand name to more than 600 customers in North America, Europe and Asia. PKT’s 52-week trading range is $10.12-$25.99. At mid-day May 2 it was trading at $11.22, with a market cap of $229 million. At market close May 21 PKT was trading at $13.89, down 3 cents for the day, with a market cap of $282 million.

* Denotes client of Allen & Caron Inc., publisher of this blog.

Whither Tech Investment Banking? Peter Blackwood Talks about Deal Flow and What’s Hot

Peter A. Blackwood is a Managing Director, and heads the Technology & Media investment banking group at Philadelphia-based Janney Montgomery Scott LLC, a bank whose roots go back to 1832, and probably the most prominent mid-Atlantic regional full-service investment bank, broker-dealer and asset manager (with more than $55 billion in assets under management).   Prior to joining Janney in 2009, Peter was a Principal and Head of the Internet & Digital Media Group at Merriman Curhan Ford & Co.  He joined Merriman from SoundView Technology Group, and began his career at E*OFFERING, a startup investment bank later acquired by SoundView.  He went to school at Ohio Wesleyan University.  pabmugshot

I met Peter at Merriman not quite 10 years ago when we were working with a digital media company headquartered in London, which was at length acquired by a larger digital media company that Peter had worked with.  We had a chance to talk on April 16 about the current state of the technology industry vis-à-vis investment banking, and what he foresees for 2013 in terms of deal flow, what he sees as “hot” in technology these days, and what kinds of public and private deal structures are most common in this market.

JA:  How is 2013 compared to 2012 in terms of deal flow?

PB:  The first few months of 2013 have been busy for us.  A number of transactions we were working on last year were delayed as people worried about the negotiations in Congress over the sequester, and moved into this year.  In the first quarter our team was quite busy executing and completing these transactions, as well as evaluating and pitching new business opportunities.  With regard to Q2 and the balance of the year, we are witnessing a marked increase in activity with regard to public offerings, both with companies selecting underwriters and working through the registration process.

JA:  Interesting that you mention IPOs first.  What is the situation these days with regard to IPOs vs PIPEs?

PB:  Over the past 2 years, PIPEs, or Private Investments in Public Equities, have fallen somewhat out of favor.  Today traditional unregistered PIPEs from the mid-2000s are few and far between.  We are seeing a preference for Registered Direct (RD) offerings, and even more for CMPOs or Confidentially Marketed Public Offerings, a variant of RD offering.  Both the CMPO and Registered Direct offerings are based on shelf registrations, but the Registered Direct is an agented offering and the CMPO is an underwritten offering.

Many issuers now prefer a CMPO structure because it opens up the number of institutions that can participate due to the underwritten vs. agented format.  Some institutional investors have charters that restrict their ability to buy agented offerings vs. underwritten offerings – which means they are excluded from Registered Direct offerings, because they are not underwritten, even though they are fully registered and tradable.  The difference is that the CMPO provides a publicly-filed prospectus supplement prior to pricing, even though it is marketed to a limited number of institutional investors, so the fact of the offering is public knowledge, and it can be underwritten by the investment bank.  As a result, CMPOs have been quite popular over the last few years.

With that said, this year we are beginning to see a bit of resurgence in structured deals, or PIPEs.  We are learning that buyers are more risk-friendly now than they have been for a few years, and are looking to invest in structured deals, which are most commonly PIPEs with common stock and warrants, with registration being filed only after the deal is completed.

JA:  How about size of deals?  Are you seeing small-caps back in the public offering market?

PB:  At our firm, and particularly in technology, the size of companies we deal with is quite broad.  For example, we recently closed a sell-side advisory deal for under $20 million, and are actively working on several deals over $200 million today.  For us, deal size is not the primary motivational factor for new business, but is rather driven by our ability to add value to help a client achieve their goals.  So, if we see an emerging technology that has potentially great demand, we will look to be involved regardless of the size of the company.

On the financing front, today we are primarily oriented toward working on financings for public companies, either IPOs or Follow-Ons.  When it comes to M&A transactions we will seek to work with both private and public companies.  At the moment, we are seeing venture capital at an unfavorable inflection point these days, and we’re not looking at VC deals as a result.

JA: What’s hot in terms of tech sectors?  What can we expect to see industrywide in terms of new issues?

PB:  Many companies across the technology and media landscape today are positioning their solutions as SaaS (Software as a Service) or a Cloud-based solution – for the obvious reasons pertaining to valuation.  So I would say those are two of the hottest sectors.  There are so many companies claiming to be SaaS or Cloud-based that it is creating some confusion, as a matter of fact.

Broadly speaking in software land, perpetual software licensing business is being transitioned to term-based licensing.  Companies with traditional software licensing strategies are in the midst of trying to convert these perpetual relationships to hosted and recurring-revenue models.  So we are seeing, for instance, a business that might have been 65% perpetual licenses, 20% maintenance, and 15% term licenses actively converting or sunsetting these perpetual licenses to either term licensing or recurring, seat-based licensing..  As the value proposition goes, it is more cost-efficient on the client to pay for what they are using.

JA:  What other sectors are you seeing more of?

PB:  Another emerging area that we are quite excited about is where e-commerce and technology intersect, and the emergence of next-generation e-commerce platforms, many of which are SaaS-based.

To give you a case study for the growing need for these eCommerce platforms, let me run through a brief example.  Ten years ago, if you were a company such as Best Buy, as a traditional retailer also seeking to sell goods online with the growth of the Internet.  With the rapid growth in web-based business opportunity, an entire department was created to focus on your web presence, from website creation to product description, pricing, and IT/server management. Today, much of these eCommerce initiatives are being contracted to a third-party provider due to the increased complexity with so many new customer interaction ‘channels’ being used, which is broadly referred to as Omni-Channel.

A few examples of leading brands that have outsourced their eCommerce solutions include UnderArmour and Crocs.

In pre-Internet days, maybe you would have received a catalog from someone like Best Buy, for instance.  You would flip through it and then call in your order on the telephone.  Today, with the rise of these Omni-Channels, you may still get that catalog, or you may get it digitally.  But if you get the catalog  you throw it in your briefcase and look at it on the train or bus while you are going to work.  You use your smartphone or tablet or Kindle and have a look at the items you are interested in.  You get to the office, go on your desktop and have a look at the website to see a bigger image.  You scroll down and look at the reviews.  Maybe on your way home you actually stop by a Best Buy store to look at the laptop or television that caught your eye, but then you go on home.  They maybe you make the actual purchase on the desktop at home.  So you had a catalog or a digital catalog, a smartphone platform, a visit to the store, a visit to the website from a desktop, and a purchase made from a different desktop at home.  All of these consumer touch points have to be tracked and managed seamlessly; order execution has to be flawless, and the branding has to be identical across all platforms.  The retailer, in my example, Best Buy, is now collecting information about your various visits to understand what is attracting you about the product, what you like.  Typically they do not have all that expertise in-house and have no intention of building an inside empire to address it.

Another area we are focused on is within the marketing & advertising space, and also where this content meets technology platforms.  Whether it’s the growth of video-based advertising over traditional display, or the emerging channels of mobile and social, we expect to see this ecosystem to be fertile ground for both new equity issuance and M&A activity for several years to come.

JA:  Are retail investors back in the market, or are all these deals institutional?

PB:  From our perspective, the retail investor is very much back in the market.  Janney has completed 23 public equity offerings so far this year, and retail participation from our platform has been significant across the board.  We find that the retail investor has gotten much more active on IPOs and follow-on offerings than for several years past.  For quite a while now, the retail investor has focused on yield – dividends, interest, and other forms of income.  What we’re seeing this year is retail beginning to be more open to risk by way of more traditional equity, and pursuing capital appreciation over traditional yield.

Retail investors have traditionally been more interested in large caps, but we are seeing them reach into the mid-caps now as well.  We have more than 95 retail offices at Janney, and 10 institutional offices, so we are clearly weighted toward serving the retail constituency by those numbers.

JA:  What are a couple of the deals that the tech group at Janney has participated in recently?

PB:  Over the past year, we worked with Angie’s List (ANGI) on their IPO and follow-on offering, CaféPress on their IPO, and on a secondary offering for WNS Holdings (WNS), which is a business outsourcing company.  We also recently worked on the acquisition by Lexmark (LXK) of Twistage, a unique cloud-based media management platform, and expect to continue to be active in M&A through the balance of the year.

JA:  Is Janney likely to stay regional or will it follow some of the other middle-market banks and go national or international?

PB:  Founded in  Philadelphia in 1832, I would say it is a safe assumption that Janney is and always will be a mid-Atlantic firm.  We have offices in most major metropolitan areas of the United States, but our strongest coverage in terms of sales and trading is geographically centered in the mid-Atlantic.  I am in San Francisco with a part of the technology team, and Janney has had both sales & trading and equity research here for a while but we only added investment banking here in mid 2012 – I was in Philadelphia before that.

Janney’s capital markets presence has seen significant growth over the last few years, across our sales & trading, research and investment banking divisions. Today, we are not seeing many new investment banks being formed.  There are some boutiques out there who are working on specialized deals, mostly in M&A.  The consolidation of Wall Street as a whole after 2007-2008 has been an opportunity for us to pick up key talent as people have been displaced from other banks.  So in many respects, the last few years have been a time of opportunity for Janney.

JA:  Thanks, Peter.

David Fondrie from Heartland Advisors: A Glass-Half-Full Guy Looks at the Sequester and Economic Growth

David Fondrie is a Senior Vice President and Portfolio Manager for the Select Value Fund at Heartland Advisors in Milwaukee (www.heartlandfunds.com).   He joined Heartland in 1994 and subsequently served as Heartland’s Director of Equity Research for ten years from 2001 to 2011.  He also held the position of CEO of Heartland Funds from 2006 to 2012.  He’s a Badger from the University of Wisconsin and served with the armed forces in Korea.  He started his career with Price Waterhouse and is a CPA.  Our paths have crossed repeatedly over the years since we had interests in some of the same companies.  Like many Midwesterners, he is a plain-spoken man.

Dave Fondrie, Heartland Advisors Inc

Dave Fondrie, Heartland Advisors Inc

We had an opportunity to chat on March 1, the day the much-discussed government spending sequester went into effect, and I asked him what he thought would happen as a result.

DF:  The headline effect is likely to be worse than the real effect.  It’s not going to be as devastating as the articles in the press would have us believe.  There will no doubt be some pain inflicted on defense stocks, for instance.  But for the most part people have been expecting this to happen, so it is not a surprise, and it is built into the market.  There are too many green shoots in the economy now for something like the sequester to knock them all down.

JA:  Are you seeing it more like a speed bump than a brick wall?

DF: Yes, exactly.  I think Congress will get around to the budget and the cuts, adjusting them to what makes more sense.  If you look around at the United States economy right now, what is striking is what is going on in the oil and gas field.  Suddenly we are one of the lowest-cost energy producers and consumers in the world.  Not only does that have a direct effect on business, it is creating a new industry that is building out the infrastructure that will allow us to provide low-cost natural gas energy to industrial America.  This has put us in quite a positive situation.

We are paying $3.50 for natural gas, where Europe is paying $12.00 and Japan is paying  $16.00.  So to me that means that companies that rely on energy for their operations are much better off here than in other major developed economies around the world.  A steel forge, for instance or a company like Precision Castparts Corp (PCP), which use enormous amounts of energy in making parts, are a lot better off here than anywhere else.  Fertilizer plants.  The renaissance in chemicals here is extraordinary.  There are 12 new ammonia plants on the drawing boards, and they all will have a reliable and lowcost stream of natural gas as both energy and raw material.  We can use that ammonia domestically and stop importing it from other economies.

LNG.  There are a number of proposals for LNG plants.  These days we are talking about exporting LNG, where we never thought about anything but importing it in years gone by.  I think this low-cost energy source is underappreciated.  In fact it will spur the continued development of oil and gas, infrastructure, chemical plants, and other types of industrial expansion.   All of that is good for the economy.  Add to that some continued improvement in employment and housing, with home prices increasing, and we foresee stronger consumer confidence, especially as a result of higher home prices.  Already 401(k) values have been improving, and it is undeniable that we are in a low interest-rate environment as well.

All this headline talk about the sequester risk is overblown.  There is no doubt that federal spending and the size of the national debt have to be brought under control.  Entitlement plans have to be rationalized.  But add to the overall situation the fact that China is clearly recovering.  Chinese electrical usage is up, their industrial consumption of materials and energy is up, and as China grows, their growth is good for the other economies that feed her growth.  Europe is not likely to get any worse.

We’re looking for 2.5% to 3% GDP growth in 2013.  The stock markets continue to be reasonably valued.  Corporate balance sheets are good; earnings are good and continuing to improve modestly.  The S&P 500 is trading at 14 times earnings, where in the past it has traded at an average of 16 times earnings.

The wild card is what happens with interest rates.  People have not yet abandoned bonds, but the inflows have receded after several years.  There have been outflows from the equity markets for five years.  Now we are seeing a trickle-back return to the equity markets.  Sadly there is a pattern that is repeating itself, with many buyers entering at the midpoint of an equity run, not at the beginning.  But this is the way cycles go.  We are in the 4th or 5th inning if you take a long view of this bull market over the last three years.

JA:  So are you buying energy companies?

DF:  Not particularly.  Low energy prices are not particularly favorable for exploration and production companies.  But we are looking closely and buying companies that supply goods and services to the energy patch.  For the last two or three years, for instance, it has been apparent that there will have to continue to be huge investments in the energy patch.  If you are drilling in North Dakota, you may have no infrastructure to bring the liquids you are pumping to the refineries, which all tend to be downriver by quite a distance.  We have huge backups in Oklahoma because there is not enough pipeline to carry all the energy.  One company we have owned for 2 to 3 years is Mas Tec Inc (MTZ).  We bought it in the 12s and it closed Friday at $30.78.  Part of their business is in pipelines, and they have also done well at the gathering systems in areas where energy is being produced at the wellhead.  Those are both high-growth areas; the stock was trading cheap two years ago, and it has given us a reward.  Quanta Services Inc (PWR) is very much the same story – we used to own that stock as well, but we sold it when its valuation reached what we thought was a sensible level; in their case they are exposed to pipeline development and new high-voltage lines.

JA:  How about life sciences companies?

DF:  The FDA has been problematic as they have increased their oversight of the industry resulting in complex regulations and inspection observations (commonly called 483 observations).   We own Hospira Inc (HSP), which was a spinout a few years back from Abbott Laboratories  (ABT).  They have run awry of the FDA at a manufacturing facility in Rocky Mount, North Carolina.  In Hospira’s case, addressing the 483 observations and revising processes and procedures has resulted in over $300 million in costs and reduced output of drugs that are already in short supply.  We are all concerned with safety; however those concerns should be balanced with a sensible and timely regulatory process.

JA: Does that put a caution flag out?

DF:  I can’t speculate on what kinds of furloughs the FDA will have to put into effect.   I doubt that we will have chickens rotting on processing lines waiting for FDA inspectors as the press and certain congressional members have suggested, but the big issues around drug approvals will continue to be important, and is likely to be slowed down even further with the automatic budget cuts.  Hopefully they will prioritize their cutbacks and the expense reductions will have less impact than we might expect.  But government does not always work very efficiently.  We hope they will be smart and furlough the poor performers instead of just following  a LIFO pattern.

JA:  How do you feel about ObamaCare and stocks?

DF:  I do sense that there is a bit more thought being given to the impact of ObamaCare.  We just reviewed the 2014 Medicare Advantage benchmark payment rates by the Centers for Medicare and Medicaid Services (CMS), and the cuts were more draconian than expected.  But the government was clear that they are not trying to cripple the HMOs because they are a vital part of the new program.  I am a glass-half-full guy most of the time, and I think if people sit down and talk they can get to some reasonable results; let’s hope that happens.  There is always give-and-take with reimbursement rates, and they end up meeting someplace in the middle.  US businesses are resilient; once they know where the boundaries are, what the rules are, they adjust.  What happens is what you expect in a capitalist system: change comes quickly.  Capitalism works pretty well.

JA:  Where do you think people ought to be looking in the equity markets this year?

DF:  I am in the camp that says we will continue to have a modest economic recovery.  In that kind of environment you have to look at cyclical companies.  We are overweight in industrials and information technology companies.  Everyone is going to look at productivity, and technology is important there.  People will continue to invest in technology to improve productivity.  We are going to be hooking up all kinds of machines at home and in factories to the Internet.  We think tech plays work.  We might stay away from actual PCs, but mobility will continue to expand, and downloads will continue to grow, keeping  Internet growth robust.  Probably financials are good, due in large part to a stronger housing market.  We are a little more cautious on that because the interest rate environment does not allow much net interest rate gain to banks.  But housing will drive loan growth, and the banks have plenty of capital to lend.  With business loans at 3.5%, it is hard for banks to make money.  If we got an uptick of half a percent, it would do wonders.

In tech companies, we like Cisco Systems Inc (CSCO).  We see Cisco as a chief enabler of the infrastructure of the Internet.  Cloud computing is driving a lot of internet traffic.  Cisco is cheap at 12 times earnings, and there is that nice dividend yield of 3% too.  The balance sheet is pristine; altogether it is a very attractive risk-reward proposition.  I run a value-oriented multicap fund.  Cisco is seen as a growth stock, but right now it is also a value stock.  They have gotten their act together after some unwise acquisitions a few years back; we think the downside is minimal.

JA:  What about social media?

DF:  Social media doesn’t really fit our style.  Even Google is not in an area where we play.  Thematically I like agricultural plays like Archer Daniels Midland Company (ADM).  It is trading a bit above book value, and the dividend yield is 2.4%.  If we have a big corn crop, ADM is going to benefit from processing all that corn.  I believe we will have a big corn crop this year, and we need one.  ADM’s PE is under the S&P 500.  I can’t predict the weather, but we are getting moisture that we badly need in the Midwest, so the water table can support strong crops this year.  We’re looking at fertilizer companies, seed companies, and farm equipment (especially on a dip).  Railroads are a bit expensive right now, but it is worth noting that the number of rail cars carrying oil is growing at 25%, which makes those cars part of the infrastructure for moving energy.  Oil companies and refiners are buying those cars and the rails are moving them.  We’ll buy rails on dips too.

One final area that is more in the later innings is deepwater offshore.  We are particularly interested in drilling off the east and west coasts of Africa.  We like the companies that build out those platforms and subsea infrastructure to bring that oil to market.  We like the boat companies that service those rigs.  These are long-cycle investments; the big international oil companies don’t start-and-stop those projects.

JA:  What about shipping companies?

DF:  There may be too much capacity there.  OSG went bankrupt.  What has happened in the US is that we are importing less oil than we were five years ago, and the amount we are producing here has increased.  Our demand for oil from overseas has decreased.  So tanker ship demand has decreased as well.  If China starts to really boom again, that could absorb some of the excess capacity, but I don’t see that as near-term.

JA:  How about the greenback?

DF: The euro is at risk, but the dollar should hold its own.  If the Chinese let their currency float more that might affect the dollar, but for now the dollar is fine.

JA:  Is there an upside to the 2.5% to 3% GDP growth you mentioned?

DF:  Maybe in the back half.  If we resolve our government problems, that might restore more confidence.

JA:  Thanks, Dave.

Allen & Caron owns none of the stocks mentioned in this interview, and Joe Allen owns none of the stocks mentioned in his personal accounts.  Please do your own research.  JA

Warren Isabelle: 2013 Will Be A Stock Picker’s Market

Warren Isabelle is a Managing  Member of Ironwood Investment Management LLC, located in Boston.  Ironwood is a prominent small-cap investor, defining small-cap as below $2.5 billion in market cap.  Prior to forming Ironwood in 1997, Warren was Head of Domestic Equities for Pioneer Capital Growth Fund, Pioneer Small Company Fund and  several institutional portfolios.  Before joining Pioneer in 1984 he was an analyst with Hartford Insurance Company.  He is a bit of a polymath, with a U Mass BS in Chemistry, an MS in Polymer Science and Engineering, and an MBA from Wharton.  He has been the subject of articles in Barron’s, Business Week, Forbes, Fortune and The Wall Street Journal.

I first met Warren at Pioneer in the early 1990s, and had the pleasure of talking to him late last week about his outlook for the year ahead.

WIPhoto

JA:  What are your predictions for 2013 overall, and what kind of market do you think we will be seeing?

WI:  This year my crystal ball is as murky as I have ever known it to be.  The crosswinds that are blowing are not gentle breezes; they are pretty stiff gale winds.  I think we will see some growth spurts in the market this year, and some retreats, but frankly I don’t see a heck of a lot of progress being made this year for the overall market.

Businesses have been on a roll the last four or five years in terms of improving productivity, cutting expenses, improving margins, and so forth.  A lot of companies are making money hand over fist, but until we get some macro issues sorted out, those crosswinds are going to make forward progress difficult.

2013 should be a stock picker’s market.  We will be looking for companies that can maneuver through the times ahead.   The market will have a hard time breaking higher ground, but we are stock pickers and always have been, and if we can continue to do our job well, our investors will be rewarded.  The world is so concerned with the macro issues; it pays dividends for us to pay attention to those.  On the plus side, we do have easy money – the cost of capital just seems to get lower and lower and though the recovery does not seem all that well established, you might say that time tends to heal all wounds.  There are green shoots here and there, and that will continue.  Small caps generally do better in a developing recovery, and we expect that to continue.

On the other hand there are plenty of mines that could explode and cause big problems.  As such, we have to be careful of stock trading liquidity.  One thing that has benefitted us at Ironwood over the last few years is that we have been much more willing and able to maneuver with individual holdings and as a result, our performance has not suffered from liquidity issues as it has in the past.  Before that we used to be dedicated buy-and-hold investors, period.  But since 2008 we believe we have reconsidered on that issue, and we are not afraid to hold cash now if the environment warrants.

JA:  In many recoveries, there are a lot of new companies started by people who either were laid off in the downturn, or who lost faith in the ability of their employers to continue growth.  Are you seeing any of that this time around?

WI:  Here’s my take.  I do a lot of work with the University of Massachusetts, both on the investment side for the Foundation, and on the intellectual property side with the Lowell campus.  I can tell you that the entrepreneurial spirit is as alive as it ever was.  But what has happened is that the traditional venture capital model of relatively long-term funding with an eventual IPO – has been impacted negatively by this ugly downturn.  As a result, many providers of early-stage capital have largely lost patience for long-term investments.  The era of that model being dominant, I think, is over, and that VC model has run its course.  The VC money that is being invested now, and there is less of it, appears to be being put into narrow areas like Software as a Service and Cloud Computing.  The model is shifting, and I am sorry to say that I do not think that crowdfunding will be the answer.

There just are not a lot of IPOs.  We don’t see the new-company formation process in as high a gear as it was before.   The risk-return equation is now much more weighted toward return, and light on risk.  That means deals are later-stage, and valuations are higher.  The early-stage companies are not in the mix.  Is the model totally broken?  All I can say is that later-stage deals are what we see happening now.

JA:  Do you think we will get a budget this year?

WI:  I think the House will produce a budget, and then it will be up to the Senate to modify it.   There will be a good deal of hemming and hawing and a lot of finger pointing, but I think we will get there.  A lot depends on whether President Obama will negotiate or not.

JA:  Let’s talk about sectors to watch for 2013.

WI:  I can tell you what we’re looking at.  First of all we think that because of the general uncertainty about our economic situation, “discovery” names will be interesting this year.  For example, there are many unmet needs in healthcare – therapeutics, diagnostics, and even medical devices to some extent.  If we can continue to find the names that have potential, not only will that help in meeting  medical need, but  large pharmaceutical companies and the bigger and successful biotech companies will be standing in line seeking to replenish their product offerings.  Those big companies have become distribution channels to a large extent, and they need the discovery companies to help in coming up with new products.

We tend to like companies that are local – not exclusively, but that is a bias we have.  We like to be close to the companies we invest in, knowing what makes them tick, and close geographically if possible.  If your investments are in the neighborhood, it’s a lot easier to fill in the information blanks, it seems to me.  One local healthcare company that we have owned for a while that is still relatively small is Synta Pharmaceuticals Corp (SNTA), which is in Lexington.  One thing I noticed early on about them is that with new financings, the senior management consistently invested serious money into the future of the company. Their most recent offering was also heavily subscribed by insiders.  We consider it very favorable when management is willing to take the same kind of risk that we are exposed to.

SNTA has a number of products, but I will mention its lead product, Ganetespib, an Hsp90 inhibitor.  Hsp90 is a protein that is necessary to the growth of tumors, and if you can inhibit it, the theory is that you can degrade or destroy the tumor, the more so in combination with other cancer drugs.  I believe it has shown pretty good results in non-small cell lung cancer, for instance, which is a notoriously difficult cancer with high mortality rates.  And, as I said, the insiders have put their own money on the table, which is encouraging.  SNTA has gone from $4 to $10 in the last year, but we think there could still be good upside if, with clinical success, some big pharmaceutical company decides to make a bid for them.

Another company, and one that took us a long time to get involved with, is Repligen Corp (RGEN), which is also close by, in Waltham.  I visit them every few months to make sure I stay on top of developments there.  About 18 months or so ago, they had change in their board of directors which turned out to be the first clue that the company was finally undergoing a transformation. Their legacy and main business currently is the supply of Protein A, which is essential to Protein A affinity chromatography, considered the gold standard in the purification of monoclonal antibodies.  They went on to develop some drugs, but  were never adequately structured for that, in my opinion, though over time they actually built up a pretty good cash balance.  Following several disappointments and apparent lack of focus, they came dangerously close to being perceived as something of a zombie.  Then the Board changed and they seemed to find direction and began to employ that cash.  They acquired their only competitor in Protein A and are now in a dominant position, with opportunity to really ramp up profitability by rationalizing costs and capacity.  In addition they have developed a line of disposable “column” products that are used in chromatography for the downstream purification of biologics.  This new modular approach to development and production is rapidly gaining acceptance by their customers which now include CROs, discovery companies, successful biotechs and big pharmaceutical companies.

JA: Which other sectors are you watching closely?

WI:  It so happens that through individual stock selection, we have increased our weighting in technology, and in particular we’re watching some turnarounds with interesting new agendas that are gaining traction.

First, though, I‘ll mention Extreme Networks (EXTR), which is out in California.  They make data switches, and theirs are the fastest and best products available in that category.  Why is it a great investment now?  We believe the need for ultra-high-speed data switches is here.  What has held EXTR back in the past has been the higher cost of their industry-leading switches, and while we think their management was great on the tech side, they could have been better in marketing.  Recently, a new management has come in and emphasized marketing and how to go to market.  Extreme has great products, a good balance sheet with $100 million in cash such that with good execution,  we believe the stock could  be a multiple of what it is now.

A second one – and again a local company in Westford – is Sonus Networks (SONS).  They are a comeback company who had an earlier gateway product that essentially became commoditized and is winding down now.  That is all people see about SONS today.  But they have a new product line now built around Session Border Controllers, or SBCs.  They basically hold access (a “pipe”) open for a user, something like a traffic cop, so lots of information can get through when desired.  We think that the old product decline will be offset by the growth of the SBCs over the next 18 months or so, and we think that most people in the market are looking only at the old product.  This company has a $600 million market cap with $320 million in cash.  And the new CEO is taking all his compensation in equity.  That’s impressive, and we think there is at least a double in this stock.

JA:  Fascinating.  What’s next?

WI:  We like some agricultural companies as I cannot overstate the importance of food production given the global growth of what we would call the middle class.  We are again looking favorably at Chiquita Brands International (CQB).  It is not a sexy company, but they appear to be back on track.  They went off the rails with pre-packaged salads, as the effort to boost margins and steady earnings never materialized.  They were also hurt by a bizarre tariff structure introduced by the European Union which cut deeply into volumes and profits.  Now they have new management and the emphasis is back on bananas and fruit.   All I can say is that the rough edges are smoothing out; the tariff picture is much better;  and spending is again going to their traditional business.  In past years, at the peak of a cycle, they were earning $3 a share, and the stock approached $30.  Now it’s at $8, but we think they can earn $2 a share in the near future, and if that happens, the stock ought to be at least double from here.  Yes, they have a lot of debt, but their cash flows have always been adequate.

We also like Pilgrim’s Corp out in Colorado.  Most people know them as Pilgrim’s Pride, and they are a chicken and turkey company.  They were bailed out a few years ago by JBS, a large Brazilian company that now owns 75% of the company which dampens investor interest, but we think that also provides downside protection. The stock had gone down to $3 on fears of rapidly rising feed costs, so we increased our position and the stock has rebounded nicely to over $7, with room to grow.

JA:  I have to say those were not companies I was expecting you to mention.  Anything else?

WI:  We like natural gas, and I’ll mention two companies: Rex Energy Corp (REXX) and Carrizo Oil & Gas (CRZO).  They did not help us last year but we think they are good operators which is the key to the investment thesis.  They are developing a lot of properties through fracking and drilling, particularly in areas where gas liquids are significant part of the production.  In the energy industry we are looking for companies that can acquire good properties and develop them efficiently.  Natural gas is currently in abundant supply and pricing is depressed. Of course we would like to see pricing increase, but we are much more  volume-oriented.  Longer-term, we believe we will be seeing natural gas exported from the US, and prices will come up if only because the differential between natural gas and oil is too wide. All good for the stocks, I would suggest.

JA:  That’s a lot to consider, Warren.  Many thanks.

Neither Allen & Caron nor Joe Allen owns the stocks mentioned in this article, nor do we anticipate initiating positions in the near future.  Please do your own research.

Buzz Zaino: Royce Fund Manager Sees Strong Growth Upside for 2013, Boosted by Housing, Transportation, IT Spending

ZainoB_gBoniface A. (“Buzz”) Zaino is a portfolio manager advising several of the high-profile Royce Funds, to wit, the Royce Opportunity Fund and associated funds. By any measure a veteran of the industry, Buzz has more than 40 years of experience in the financial services industry, the last 14 with Royce. I first met him when he was managing the Value Added Funds for Trust Company of the West more than 20 years ago, but prior to that he was president of the Lehman Capital Fund and a principal of the “original” Lehman Brothers. He went to school at Fordham, and took his MBA from Columbia. In 44 years, Buzz has seen enough economic cycles to offer an MBA from the University of Zaino.

Buzz agreed to talk about his 2013 outlook from his home in Aspen which, like much of the US snow belt, has seen little of the white stuff so far this year.

JA: It seems generally agreed that the US economy is growing at a slower pace than it has coming out of previous recessionary periods. What is your outlook for 2013? Will the economy continue to grow, and if so, will it grow at the same rate, faster or slower?

BZ: The reason that the US economy has had a slow lift-off has been that coming out of recessions in the past, the Fed has lowered interest rates, and people took that opportunity to buy houses and cars. This recession was different, because the banks were not giving out money, because money was scarcer and because bank lending standards were significantly more stringent. So there was a hiatus and it took a lot longer for the economy to recover. The recovery finally started this year, 2012, and it is finally beginning to give a boost to the economy, especially as construction gets going again. That boost is going to continue, and it will help us accelerate in 2013. But the recovery was complicated by the fact that Europe went into recession. American companies tend to be worldwide in scope, and caution at the top levels helped bring inventory levels down due to the European recession. That meant that capital spending was also muted. I think that capital spending is also constrained in anticipation of the budget settlement that is still out in the future. A “normal” recovery was delayed until 2012, and then delayed again by the European recession. But those delays now give us the opportunity to accelerate as 2013 progresses.

JA: Will we get a budget?

BZ: Sooner or later, yes. We will get a budget deal out of Congress. Once we have that deal defined, we can go forward from there. That will be a positive, and will be on top of the acceleration we can expect from normal factors like housing and auto sales. We could get a nice surprise in 2013. But we’re cautious about January.

JA: Why is that?

BZ: Most managers will make their January decisions based on their December orderbooks, and we don’t think the December orderbooks will be strong enough to give them confidence, but as we go into February and March, a lot of the inventory build-up will have started to occur, so the orderbooks will look better. And the trade between China and the US is expanding again, after a period of slower growth. We think that could have an increasing effect, especially after the Lunar New Year. By the end of the first quarter, growth could be looking quite good.

JA: The harsh talk by Washington DC and Beijing won’t slow down that growth?

BZ: The China-US trade is too big a market for both sides, and politics will not interfere with it. Certainly the Chinese government’s expansion plans are not going to be held back. There are Chinese hotel companies looking for hotel properties in the US – to build or to buy. Very smart people, and I don’t think either side is going to let politics inhibit our trade relationships. Nothing is going to come of the yelling.

JA: Will the growth rate be higher going into the second quarter then?

BZ: I think we could have a weak-ish economy and market in January, like I said. Everyone will be paying higher taxes, at least with FICA deductions back in everybody’s paychecks. With orderbooks in December that may not be strong, managers and consumers could still have their hands in their pockets. If we have a warm winter like we had last year, we could have more construction starts. If we have a cold, snowy winter, those starts could be delayed, and the weak period could extend through January. We are looking very favorably at housing. Housing is still somewhat depressed, but the housing stock is aging — and mortgage money is more available than it was a year ago. And the automobile fleet is aging and will need to be updated, as will the commercial truck fleet.

JA: Do you think the growth rate will exceed 2%?

BZ: Yes, better than 2%, but maybe not in January. But after that it could be substantially more than 2%. Four to five percent would not be out of the ballpark, although 5% would be at the high end of probability. And the market would react to that. If the market is down – and cheap – they don’t want to buy, but if it goes up 15%, everybody wants to buy. If UPS starts to replace its fleet and buys trucks, all the others will update their fleets at the same time. It’s much cheaper to run your truck or your fleet on CNG (compressed natural gas) too. A town near Aspen has converted their entire bus fleet to CNG, and although they can fuel up at the bus barn, there are additional CNG stations being built. Boone Pickens and his group are encouraging these new CNG fueling stations. We’re surprised that trucking companies are not moving faster than they are toward natural gas. We have an investment in a building materials company and I asked them if they are considering CNG, and they said they had not looked into it, but they would. Conversions to CNG are not expensive. Ford and GM are now offering pickup trucks with CNG engines.

JA: Is there going to be a fiscal cliff solution?

BZ: Eventually. Whether or not it happens before December 31, there’s no way to tell. But the congress can pass a continuing resolution to postpone the cuts and tax increases while they work on it. Eventually this Mexican standoff will be resolved. And by the way, the fiscal cliff does not seem to be a big motivator for the American consumer. They need to replace things, and they are not overly concerned with the big picture as long as the economy seems to be getting healthier.

JA: What sectors are going to do better as the economy improves?

BZ: IT spending will pick up. There is a big pent-up need factor here, and it has been a relatively easy way to postpone expenditures for the last couple of years. Windows 8 is very much under-rated. It takes a while for people and corporations to decide to make a big change like the change to Windows 8, but it will be very good for PC companies. Corporations need to have the latest and fastest. Technology in corporate environments needs to be the newest and most capable. Areas like IT are why you can think of higher growth rates. After this hiatus, there is enough pent-up need to start a new momentum.

JA: How about healthcare IT?

BZ: I went to see my physician in New York, and he is one of the best, highest-rated doctors in his specialty. He was really annoyed that he was going to have to convert my file, which is a manila folder with all kinds of paper and bits of paper in it – to computer files. I thought, hey, this is 2012, get with the plan.

JA: How about housing? Any areas there where investors ought to be looking?

BZ: We have had a good run with housing companies, and we think that will continue. One area that may have real potential is mortgage insurance companies. It is a fairly narrow field, and some people infer from the papers that these companies may not be able to cover their losses. The reality is that housing prices could be moving up at a rate of nearly 1% per month in the near future, and as a result those liabilities would be decreasing. Mortgage applications for refinancing were up last week 47% year over year. That’s a meaningful number. Apparently not everyone is under water. Those areas that have dropped the most are improving the fastest in some cases. California is one of those.

JA: Any areas where you would be wary going forward?

BZ: Defense companies. We think there will be lots of cutbacks, lots of programs cancelled. Defense personnel contractors may do better as the armed services cut back their personnel. Company by company there may be some good bets in defense, but we believe the sector will be down.

JA: And in summary?

BZ: Other than defense, it is going to be a broad-based recovery. If we have a growing, recovering economy, interest rates would rise, and inflation would rise. Commercial banks will do better. They will use their asset bases to increase lending. The moderating factor will be that regulations will add some cost, but that will not be an inhibitor for the larger banks looking to expand regionally. If I were a larger bank and wanted to expand regionally, it would be attractive to me to buy a regional bank and expand my profitability without appreciably expanding my regulatory exposure.

JA: Thanks, Buzz.

Note: Buzz prefers not to name specific companies in his portfolios. The interviewer has no investments in the sectors discussed, and does not intend to initiate such investments in the next few days or weeks.

Successful IPOs End Languid Stretch, Send Strong Signal to the Market

Five IPOs, each fetching a price at the top end of their initial estimates, cast an optimistic glow on the market for the week ending Oct. 12, according to the Wall Street Journal (http://online.wsj.com/article/SB10000872396390443294904578053012301202162.html?KEYWORDS=ipo+outlook+chris+dieterich). The five successful IPOs also ended what the WSJ termed a “dull spell” and a “languid stretch for IPOs.” That each of the five companies came from different industries was also a strong signal for the market and it was the first time in 10 years that “five IPOs shot that high in tandem,” according to the report.

Photo courtesy etftrends.com

Much was made of the Workday Inc. (NYSE: WDAY) debut, which jumped more than 75 percent. The Pleasanton, CA-based provider of human resources software continued to run on Oct. 15-16, and was all the way to $52.70 at mid-day Oct. 16. Parsippany, NJ-based Realogy Holdings Corp. (NYSE: RLGY) , formerly Domus Holdings, which provides real estate and relocation services, climbed to $35 by mid-day Oct. 16. But those two companies have market caps of $8.5 billion market and $4.6 billion, respectively, placing them out of our small cap focus.

The other three IPOs, including Shuttterstock, Inc.; Kythera Biopharmaceuticals and Intercept Pharmaceuticals, are small caps and therefore squarely in our sweet spot.

New York City-based Shutterstock Inc. (NYSE: SSTK, http://www.shutterstock.com/) operates an online market for digital imagery including licensed photographs, illustrations and videos. SSTK was founded in 2003. By mid-day Oct. 16, the third trading day after its debut, SSTK was still climbing to $23.01 with a market cap of $754 million.

Calabasas, CA-based Kythera Biopharmaceuticals (Nasdaq: KYTH, http://www.kytherabiopharma.com/) is a clinical stage biopharmaceutical company that develops and markets prescription products for the aesthetic medicine market, initially the facial aesthetics market. Its first drug, now in Phase III clinical development, reduces  double chins. At mid-day Oct. 16, three days after its debut, KYTH was soaring, up 18.6 percent to $24.61 with a market cap of $427 million.

New York City-based Intercept Pharmaceuticals (Nasdaq: ICPT, http://www.interceptpharma.com) develops and markets therapeutics to treat chronic liver disease. Its lead product candidate was developed initially for the second line treatment of primary biliary cirrhosis. Three days after its debut, ICPT continued to trade strongly and by mid-day was up 22 cents to $19.48. Its market cap is now $307 million.

Report: Investments in Smart Grid Technologies to Reach $200 Billion by 2015

New investments to so-called Smart Grid technologies to replace the current decades-old electrical grid technology will total $200 billion worldwide by 2015, according to a recent research report by Pike Research, a market research firm that specializes in global clean technology markets (http://www.pikeresearch.com/newsroom/smart-grid-investment-to-total-200-billion-worldwide-by-2015).  While smart meters are “the highest-profile component of the Smart Grid,” the investments will mostly go to “grid infrastructure projects including transmission upgrades, substation automation and distribution automation,” said Clink Wheelock, Pike’s managing director.

If accurate, that opens up a whole lot of potential revenue for a wide variety of companies large and small. Some of the bigs include Qualcomm, Duke Energy and JDS Uniphase, just to name a few. But several small caps are thriving in different niches of the market. Here are a few randomly chosen companies involved in this market.

Newton, MA-based Ambient Corporation (Nasdaq: AMBT, http://www.ambientcorp.com/) provides utilities with solutions for Smart Grid initiatives. It has designed a secure, flexible and scalable smart grid platform called the Ambient Smart Grid communications and applications platform. Ambient announced Oct. 4 that it was establishing a European subsidiary to focus on the “growing and vibrant” European market. AMBT has a market cap of $83 million and a 52-week trading range of $4-$9.75. It closed Oct. 9 at $4.89, down 11 cents on the day.

San Jose, CA-based Echelon Corporation (Nasdaq: ELON, http://www.echelon.com/) is an energy control networking company. Echelon technologies currently connect more than 35 million homes, 300,000 businesses and 100 million devices to the smart grid. ELON offers a wide variety of products focused on smart buildings, smart cities and the smart grid and it recently announced that two of its products were granted China State Grid approval. ELON’s market cap is currently $166 million and its 52-week trading range is $2.50-$7.43. It closed Oct. 9 at $3.88, down 5 cents on the day.

Irvine, CA-based Lantronix (Nasdaq: LTRX, http://www.lantronix.com/) makes products that make it possible to access and manage electronic products over the Internet or other networks. The company offers smart machine-to-machine connectivity solutions and other miscellaneous products that offer remote access, control and printing for data center, enterprise manufacturing, branch office and home applications. LTRX has a current market cap of $27 million and a 52-week trading range of $1.15-$3.40. It closed Oct. 9 at $1.82, down 12 cents for the day.

Calabasas, CA-based National Technical Systems * (Nasdaq: NTSC, http://www.nts.com/) is a diversified engineering services company, providing a wide range of testing and engineering services to the aerospace, defense, automotive, telecommunications and energy industries worldwide. NTSC now offers a comprehensive certification program for Smart Grid devices that includes areas identified by major utility companies as vital for new products in Smart Grid networks. NTSC’s market cap is now $86 million and its 52-week trading range is $4.02-$8.80. It closed Oct. 9 at $7.48, down 8 cents for the day.

* Denotes client of Allen & Caron Inc., publisher of this blog