For investors these days, the light at the end of the tunnel known as the economic recovery is not as consistently bright as they'd like it to be.

But Richard Driehaus, chairman of Driehaus Capital Management, a Chicago mutual fund company known for its aggressive small- and mid-cap momentum investing style, has his eyes firmly on the prize. He believes the market bottomed last September and that the economy is beginning to show fits and starts of a recovery.

Richard Driehaus
Chairman,
Driehaus Capital Management
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Perhaps even more surprisingly, Driehaus funds own a number of Internet stocks, including search engine Overture ( OVER) which is down 11% year to date through Feb. 14 after returning 385% in 2001; and Websense ( WBSN), an Internet-tracking company that has followed a similar, though less dramatic pattern. This stock is down 13% this year after returning 121% in 2001.

Such swings don't make Driehaus uncomfortable, he says, because these companies have strong earnings and growth. There are many other stocks like these that are poised for growth, he adds.

Read on to learn which other stocks Driehaus likes.

TSC: One of your recent white papers gives a number of complex, technical reasons for your strong faith in small-cap growth stocks. Can you explain what some of this technical analysis and research means?

Driehaus: First of all, we don't buy stocks just because they're down. We buy stocks because there's fundamental as well as technical improvement. We think the market bottomed last September.

We also think the economy is in the process of bottoming, that we've probably seen the worst because the inventory buildup that was there a year and a half ago is now clean. In fact, I think this is one of the largest inventory corrections, or drawdowns, ever. In other words, the pipelines and the distribution channels are relatively empty now. So any type of increase in demand will follow through with an increase in production.

This recession was a capital-based one, based on excess capacity, as opposed to a downturn in consumer spending. So it was really about inventories, and now, we believe, these inventories are in line.

So we're positive on the economic outlook, and we're also positive on equities, vs. safe asset classes, like cash, Treasury bills, bonds, certificates of deposit, etc. Interest rates are low, there's a lot of money on the sidelines and we're in the early stages of an economic recovery. And there's also been a tremendous correction in the technology and health care sectors. They've had a huge shakeout. A lot of these stocks are selling from figures that would represent the temperature on a hot day in an Arizona summer to a woman's single-digit dress size.

TSC: Can you name any specific small- and mid-cap growth stocks you hold in your portfolios right now?

Driehaus: Sure. There's been this inventory shakeout, so there are areas that have good, strong demand, like DVDs, flat-panel displays, Internet security and graphics chips for these games. Advertising, believe it or not, is beginning to rebound as advertisers return to content providers, like Univision ( UVN), because consumer spending has held out. So there are some areas in technology and media that are relatively strong.

One of our largest holdings, and it's been a little controversial, is a company called Overture, formerly known as GoTo.com. That's a good name. Overture is a premier provider of pay-for-performance Internet search. They are very, very strong in both revenue and earnings growth, and that's one of the things we look for. We also saw an increased number of advertisers for them, many even increasing their expenditures.

Another company that we like is Websense, a company that enables businesses to report and manage how their employees use the Internet. Revenues for the quarter ended in December were $11.3 million, vs. an $11.1 million consensus estimate. It was up 19% sequentially from the previous quarter and 95% year over year.

In the consumer cyclical area, another company we like is a restaurant franchise called Panera Bread Company ( PNRA). They operate a bakery/caf¿ business under the name St. Louis Bread. And they recently reported a very strong September quarter, where the earnings were 20 cents as opposed to the consensus of 19 cents. They were up 67% year over year. Revenue rose 34% year over year, and 11% sequentially, and the estimates were increased for this company, which is benefiting from a trend toward more value-based eating. In other words, lower cost and quick service.

Here's another name we like: Coinstar ( CSTR). They are the only nationwide network of supermarket-based, coin-counting machines. Same-store sales growth was up 19% for the December quarter, vs. an 8% estimate. And that's up from a strong 14% September quarter. The average revenue per machine was $15,400, vs. $14,400 in the previous quarter. And their current earnings estimates are up around 62 cents for this year and $1.50 for the following year. And they have terrific cash flow.

TSC: Is it hard to find good small-cap growth stocks at this time?

Driehaus: The classic way we tend to buy stocks -- which is by looking for stocks that have been hitting new highs and following an aggressive momentum style -- has been harder to apply because there are not that many classic names out there. Our style works best in what they call a "trending market" rather than a rotational market. So, in some cases, we're buying what we call "recovery growth," which is buying stocks that are down considerably from their highs. But out of a period like this, you can get substantial gains.

Let me give you an example of that. One of our favorite stocks right now is a company called NetBank ( NTBK), an Internet banking company. They recently made a strategic acquisition, a little mortgage company that will allow them to expand their profit margin because, before, they could attract deposits, but they had to pay a lot to source loans from outside parties. Now that they have the ability to internally source that, they can pick up the spread.

TSC: It's very interesting that of the stocks you have mentioned so far, four are Internet stocks.

Driehaus: Yeah, well, these are the survivors. These are the ones that are going to do well. In fact, another Internet one we like is Ticketmaster ( TMCS). They have three lines of business -- online ticketing services, which has limited competition and is 83% of their revenues; personal subscriptions; and an online matchmaking service, and that's growing very rapidly. It looks very interesting, also.

TSC: Late last year you were saying that you were predicting a recovery by the middle of this year. Is this still your position?

Driehaus: We were predicting both that the market had bottomed in September and a recovery for the market over the course of 2002. What we've had is a very choppy and, frankly, very disappointing start. I didn't anticipate some of the more negative surprises still coming out in the tech area.

The recovery is going to be there, but it's going to be slow, staggering and uneven. We don't see any strong sector leadership; it's more individual ideas. But we think the recovery is going to be reasonably long-lasting, and will take place sometime over the next 12 to 18 months.

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