On the Level: It's a Small-Cap World, After All

Forget about Amazon.com(AMZN Quote - Cramer on AMZN - Stock Picks). If you want to make money in tech, or at least lose less in a downturn, look away from the usual big-cap suspects and cast a glance instead below the radar screen. Visit, for a moment, the land of beaten-up and ignored small-cap growth stocks.

You might ask, "Why look at companies I've never heard of that are followed by few Wall Street analysts when I could own giants like Amazon, Cisco Systems(CSCO Quote - Cramer on CSCO - Stock Picks) or Yahoo!(YHOO Quote - Cramer on YHOO - Stock Picks)?"

Two important reasons -- valuation and stock price performance.

Let's talk valuation first. Small-caps in general are still cheap compared with the big boys, according to Andrew Engel, a senior analyst with the Leuthold Group, a stock market research outfit based in Minneapolis.

"Small-caps are still quite appealing compared to large-caps," says Engel. Leuthold data going back to 1972 show that small- and mid-cap stocks today are still selling at historically huge discounts to large-caps. Looking at P/E ratios for small and large stocks, the researchers at Leuthold have found that the current small-stock discount -- about 57% -- is greater than at any point since the market bottom in 1974-75.

But why should we think that small-cap stock prices will eliminate that discount any time soon? Because, says Engel, "coming out of a recession, and we see this as perhaps a mild recession, small-cap stocks tend to do better than large-cap stocks. They typically recover faster and show better earnings. Why? They tend to be more nimble and adapt products and pricing to the new conditions, as opposed to an ocean liner of a big company."

Of course, this analysis applies to all small-cap, not just small-cap growth stocks. But looking anecdotally at examples of small-cap growth stocks, you can see that they, too, are often cheaper than their bigger brethren. The examples presented here come courtesy of the father-and-son team of Carl and Brian Hathaway of Hathaway & Associates, an investment management firm based in Rowayton, Conn. They manage $310 million for pension funds and another $15 million to $20 million in a higher-risk hedge fund for private clients. The Hathaways have done pretty well since 1995. Their institutional portfolio gained 102% net of fees; in comparison, the Nasdaq industrial index, which they use as a benchmark because it excludes the financials, rose 97%.

Carl Hathaway also has a unique perspective on the market. In the go-go days of the late 1960s and early 1970s, he was head of the stock-research department for Morgan Guaranty, which at that time had a lock on the business of the biggest institutional investors. Hathaway is credited with inventing the "Nifty-Fifty" -- the short list of big-cap stocks that led that bull market and subsequently cratered in the downturn.

Room to Roam

Today, Carl and his son are strictly small-cap growth-stock investors who stay with companies that have annual revenues below $200 million. They believe that last year's tax-loss selling was so severe that even after the January rally, their stocks are not overpriced. In December and earlier this month, they loaded up and now are fully invested. They say that the typical trailing 12-month P/E's for their stocks is about 30 to 35, considerably below the Nasdaq Composite's 100-plus P/E.

Universal Electronics (UEIC Quote - Cramer on UEIC - Stock Picks) is typical. The company makes the technology that goes into all those handheld universal remotes used at home to control the television, VCR, stereo and whatever other video and audio entertainment equipment you may have. Hathaway says that Universal has a 20% market share. It sports a trailing P/E of 25, but profit estimates for 2001 were just raised to 95 cents; that implies a forward P/E closer to 20. That does not seem out of line for a company whose revenue and profits per share have been growing far faster than 20% in the past year. They loaded up at $14 to $15 per share, and the stock ended today at $20.50. So it has had a nice run in January.

A Universal Buy? Stock's had a nice run in January

Source: BigCharts

The Hathaways believe that Universal can sustain its current growth. They reason that as cable companies upgrade their systems from analog to digital modems, the market for handheld remotes made by Universal should grow apace.

Whether Universal catches your fancy is not the point. Admittedly, this doesn't look like the next Cisco. But, on the other hand, why should you pay up for Cisco, whose trailing P/E is still north of 90, when the company has shown recently that it, too, can disappoint just like any other company? No, the idea here is to get you thinking about an entire world of munchkins that most people don't even consider when they think of tech.

We now return you to Amazon.com.