Small-Caps Keep Chugging, Thanks to Wellspring of Financing

Rhyme & Reason

SAN FRANCISCO -- Small is beautiful. Good things come in small packages. It's not the size of the wave, but the motion in the ocean.

All the cliches about stocks great and small are currently applicable to Wall Street, where the Lilliputians continue to rule. While blue-chips slumped and the Nasdaq sputtered today, the Russell 2000 rolled merrily along to yet another record close.

The action continues to astound market players, even those who are participating in what -- to some -- is surefire evidence of speculative, excessive and maniacal activity.

For example, TeleHubLink (THLC) traded under 2 a share from February 1999 until just recently. Today, the stock leapt 48% to 19 on rumors Bill Gates would take a controlling interest in the provider of telephony and e-commerce technology and services.

On Feb. 14, I took an initial look at what was making stocks that had floundered for years (in some cases) suddenly head skyward. Today, I spoke with Satya Pradhuman, small-stock strategist at Merrill Lynch, who offered a rationale for why the move by small-caps might just be rational, after all.

Pradhuman conceded the "absolute numbers" sported by some small- and (former) micro-caps are "daunting," but said the action is a result of an improved access to financing for smaller companies.

The spreads between rates at which most blue-chips can borrow and financing available to smaller firms have been "unusually wide" in recent years, the analyst said. They began to sour in 1994, when the Federal Reserve embarked on a series of rate hikes and kept curdling until after the emerging market debt crises of late 1998, he said.

At the nadir in late 1998, Pradhuman estimated the spread between LIBOR -- the rate at which most blue-chips can borrow -- and subprime loans available to smaller companies widened to as much as 6%.

"I do think this explains the mystery of why smaller companies weren't faring much better in the last four or five years," he said.

But in the past 12 to 18 months, the situation has "improved sharply," with the spreads "cut by half," he said. It's not so much that absolute lending levels have come down for smaller companies, but that they've improved vs. blue-chips on a relative basis.

Even the Fed's four rate hikes in the current cycle have lent unintended assistance to small-caps as they've "taken away the free lunch the large blue-chip firms have enjoyed" in the form of extremely low bond yields.

Furthermore, the increased use of mezzanine financing in the private-placement market suggests "spreads might not reflect how improved the relationship really is," he continued. "If you can get cheap capital to small, unknown companies, their market caps will go through the roof."

That's certainly been the case for many stocks so far in 2000. But even the small-cap advocate acknowledges there's a "dark side" to this otherwise happy tale.

"Every step the Fed tightens says the equity risk premium is going up," Pradhuman said.

In other words: The gnat can elude the elephant's tail only for so long.

Lehman in the Lurch

Software analyst Michael E. Stanek is leaving Lehman Brothers to join Garage.com, market sources tell The TaskMaster.

In a strange twist, a Lehman Brothers spokesman (who shall remain anonymous) first confirmed the rumor then called back to say "as of right now, [Stanek] is still Lehman's software analyst. He's in his office in San Francisco."

Perhaps Lehman made Stanek a counter-offer he couldn't refuse, but I was told the analyst wasn't in his office either Friday or today. But let's not split hairs. Bottom line: I could not reach Stanek to confirm or refute the scuttlebutt. A Garage.com spokeswoman did not return a phone call seeking comment.

If Stanek is heading to Garage.com, an online venture capital firm founded by Guy Kawasaki, it is unclear what his specific role/title will be. It's likely he'd be brought in to analyze start-up software ideas sent to Garage.com, whose mission is to link entrepreneurs with the VC community. (For more on Garage.com, see this recent story by my colleague Adam Lashinsky.)

The loss of Stanek, should it come to pass, would be the second high-profile departure from Lehman's tech team this year. In early February, Internet stock analyst Brian Oakes left Lehman for Cendant (CD), where he became chief investment officer of a new unit aimed at coordinating efforts between that firm's traditional and online businesses. (Say that five times fast.)

It is unclear what impact, if any, Stanek's departure would have on Lehman's underwriting business. With a 4.4% market share, Lehman ranked seventh among underwriters of high-tech IPOs and secondary issues in 1999, according to Thomson Financial Securities Data.

The company's spokesman raved about the firm's "deep bench" among its pool of junior analysts and its "strong" banking team. "Our underwriting business can speak for itself," he said.

Indeed, it will be interesting to see what Lehman's underwriting business has to say if rumors of Stanek's departure prove founded, especially so soon after Oakes' exit.

Even if Stanek stays at Lehman, all Wall Street firms face big challenges in retaining top sell-side analysts, who are increasingly being wooed by the VC, hedge fund and dot-com communities, especially those with high-tech expertise (perceived or actual).

For example, Charles Finnie, a former e-commerce analyst at Volpe Brown Whelan (now Prudential Volpe) joined CMGI's (CMGI) venture capital affiliate, CMGI@Ventures, as general partner earlier this year.

I hesitate to use the term "brain drain," because that would be a tacit compliment to a profession whose value to investors is spotty, at best. Sure, there are exceptions, but the "rule" among analysts seems to be to maintain bullish recommendations on stocks such as Williams Sonoma (WSM) or Lucent (LU) or Tyco International (TYC) (especially if your firm has a banking relationship), up until about five minutes after they blow up.

If and when today's highflying (tech) stocks suffer a similar turn, don't expect the analyst community to make the call until after the fact.

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