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Bottom of the Barrel: A Small-Cap Earnings Checklist

As the earnings parade begins, I've received some questions about the qualitative side of earnings for small-cap companies, like those in the Bottom of the Barrel portfolio. Numbers are key, but so is what management says about the earnings and the future. In fact, many times -- especially for small-caps with short earnings histories or even histories of losses -- the "softer side" of the quarterly report is just as important when assessing a company's future.

With that in mind, here's a quick checklist of items I focus on when listening to management discuss quarterly and annual results.

  • Examine the quality of earnings: Let's start with the obvious. We want earnings that are easy to understand and repeatable. However, I'm also always looking for good disclosure -- complete as well as straightforward. The financial statements in the earnings release and the 10-Q, when filed, should be readable by the average shareholder, and explanations should be clear and concise.

    I grow suspicious of earnings reports that are too complex or so full of minutiae that I end up more confused after reading them. For example, the Berkshire Hathaway (BRK.A) annual report is an example of simplicity. It is long and detailed, but when I'm done reading it, I have a pretty good feel for the business. Every company -- especially small-caps that are looking for investor sponsorship -- should aspire to be like Warren Buffett, at least in this regard.

  • Check out the competition: Even in a tough economy, there are winners and losers. A classic example of that is Roadway (ROAD). When I originally profiled this company last June, I expected an economic recovery to help boost the shares. Although Roadway has struggled with a sputtering economy, yesterday's earnings report suggested it was taking market share from weaker competitors, one of which is now out of business.

    Roadway had to guide its full-year earnings estimates lower, but its market-share gains will provide more upside as the economy improves. For small-caps looking to build business, building a base at the expense of competition is almost always a good sign.

  • Look for clues at related companies: Many small-cap companies depend on relationships with much larger public companies for success. Take, for example, SurModics (SRDX), a company that has helped develop drug coatings for medical stents. It depends on Johnson & Johnson's (JNJ) receipt of approval for its Cypher cardiac stent.

    When it announced earnings Wednesday, Johnson & Johnson said it would receive final approvals for the stent "very soon." SurModics was weak on the news because investors were hoping for more rapid approval. In the small-cap world, it's critical to understand key customer relationships to ascertain the real potential for success or failure.

  • Understand economic sensitivities: Just about everyone knows that the economy hasn't recovered as pundits had hoped, but it's just as important to understand the specific economic realities of small-cap companies.

    For example, while I still like Superior Industries (SUP), it has suffered from the cutbacks in the automobile industry, which has taken a bigger hit than the overall economy. Conversely, due to higher commodity prices and the need to find more natural gas, Maverick Tube (MVK) is likely to provide a rosy outlook for its business and the oil and gas economy. Understanding the economic sensitivities of a particular business and the "sector economics" is crucial to finding profitable anomalies in the small-cap world.

  • Watch the impact of demographics: One of the less successful picks of 2002 was Coachmen Industries (COA). Coachmen will continue to benefit from an aging U.S. population, assuming that older Americans retain their affinity for motor homes, but I underestimated the impact of the economy on recreational vehicle sales.

    Demographic trends are important, but typically only as a confirming, longer-term indicator. A lot of companies should have benefited from the graying of America -- drug manufacturers, health care REITs and medical-service companies -- but none has been a stellar performer because of the demographic story alone. Economics will trump demographics as a market variable almost every time.

That's a quick checklist I use as I pore over small-cap earnings reports, but many others could be added. If you have specific earnings tenets you follow for small-caps, shoot me an email with your ideas, and we'll develop a more comprehensive list together. In the coming weeks, I'll publish the best suggestions I get and make it an ongoing project.

So much for rules. Next week, a look at the portfolio over the first quarter -- complete with winners, losers and the quarterly discard pile.

Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds.

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