Bottom of the Barrel: What to Do When Everything Sinks

As the market continues to swoon, more and more stocks become possible candidates for Bottom of the Barrel. However, as stock prices get trimmed, so too do the stocks already in the Barrel, creating both nauseous feelings as well as opportunities if you're a small-cap investor.

I have little doubt that many of the companies in the Barrel provide compelling value. Yet, candidly, in the current market environment, value may not be enough.

Value Through Trust

The continued pressure on equity markets is as much about trust as it is about the economy, valuations, balance sheets or anything else. In fact, the recent selloff is largely related to the most important investing intangibles: honesty and integrity.

The new reality places a higher burden on small-caps: Companies striving to establish themselves tend to push the envelope for growth, sell potential investors on the future and have even been known to replace solid financials with fancy rhetoric and promises.

The recent scandals of former behemoths like Enron and WorldCom simply raise the bar for small-caps looking for their 15 minutes of fame. Indeed, the real small-cap successes may be those that shy away from the spotlight and stick to the game plan, execute to their strategy and simply to report their benchmarks each quarter in Walter Cronkite fashion: "That's the way it is."

Earlier this week, Jim Cramer put forth a prescient list of characteristics of today's successful companies. That wish list should be read by every CEO, and it will become a hallmark of my investment process in the coming months.

Small-Cap Checklist

At some point -- next week, next month or next year -- the focus will return to fundamental value in the small-cap sector and business plans that can lead to growth. The backbone of the domestic economy remains small business, the entrepreneur who dreams of building the next General Electric or Microsoft.

As I cull through scores of small-caps, looking for companies to profile for Bottom of the Barrel, I use the following checklist to assess the prospects:

  • A market niche: Look for small-caps with a market niche, defined either as a unique product or improvement that can add value to existing markets or as a geographical niche. Companies that are first with a product are most often winners. That's what attracts me to SurModics ( SRDX), which makes coatings for medical devices, including coronary stents. Another example is Coinstar ( CSTR), which simply created a better coin wrapper.

    Hibbett Sports ( HIBB) is a good example of a geographical niche, focused on selling sporting goods in smaller communities in the Southeast, where there's little competition for its specialty.

  • Real and sensible growth: Any company can talk a good game, but when it comes time to step up, does the company perform? Although start-ups can and will lose money for a period of time, you want to see real progress toward profitability and growth. Take a company like Rare Hospitality ( RARE), the corporate proprietor for Longhorn Steakhouses, among other popular restaurants. It has grown steadily since opening its first Longhorn in 1981 in Atlanta.

    There's nothing terribly "sexy" about a good steak and a beer, but the company continues to execute on its strategy without a lot of fanfare, and it's rational in its expectations. In fact, CEO Phil Hickey titled a section of his 2001 letter to shareholders, "Outlook for 2002: Proceeding with Sensibility," where he discussed the current operating environment and realistic growth expectations for the company in the year ahead. More CEOs should learn from Hickey's candor.

  • Solid balance sheet: There are a lot of good smaller auto-parts manufacturers, many chronicled recently by my colleague Odette Galli. But one thing sets Superior Industries ( SUP) apart: a pristine balance sheet. Superior's financials are relatively easy to understand, and the company carries no debt, a sign of strength, especially in a cyclical industry.

    That's not to suggest all debt is bad debt. These are the key questions to ask about a small-cap's debt:

    1. Is the debt service manageable with current ongoing operations? (Don't borrow using the future as hope for repayment.)

    2. Does the debt stand in support of a core corporate objective? (Borrowing to expand the core business is a sign of health; borrowing to start a tangential business on a whim is probably not.)

    3. Is debt the best form of capital available?

  • Honest management: I want a management team that can level with investors, like Rare Hospitality's Phil Hickey or Cost Plus ( CPWM) Chairman Murray Dashe, who can talk candidly about the company's largest market, California, and the need to diversify to strengthen the company. I want managers who are credible with investors and who tell the story like it is. All CEOs play the "sales" role to investors and analysts, but those who can look you in the eye and answer the tough questions are the leaders needed in this new era.

Those four tenets may seem simplistic, but therein rests the beauty. In retrospect, in a rush to justify unjustifiable practices, metrics and even valuations, analysts and investors complicated the game.

Ironically, the pain of the market swoon will simplify the investment process, keeping it simple, honest and realistic. Although the temptation to sell the story will be greatest among emerging-growth companies and the allure of rapid growth will continue to entice investors looking for a quick fix, following these rules and those of Jim Cramer should help you find winners and, more importantly in this market, avoid most of the disasters.

Value Over Growth

With recent market turbulence, the Barrel portfolio has felt the pain. With that pain comes opportunity, and I think you can find it in some of the small-cap financial stocks. Fidelity National ( LION), UCBH Holdings ( UCBH) and Coastal Bancorp ( CBSA) all have reported solid quarterly earnings with good outlooks for the second half.

Half-Full or Half-Empty?
Barrel picks swoon with the market
Current Rating Company/Ticker Date of Mention Current Price Mention Price* % Change From Mention % Change Last Week
Above Average Outlook
Superior (SUP:NYSE) July 10, 2002 $40.36 $43.87 -8.00% -1.87%
Roadway (ROAD:Nasdaq) June 19, 2002 31.24 34.03 -8.20 -2.56
Fidelity National (LION:Nasdaq) May 8, 2002 9.22 10.58 -12.85 -3.46
UCBH Holdings (UCBH:Nasdaq) March 27,2002 36.37 35.65 2.02 -3.53
Cost Plus World Markets (CPWM:Nasdaq) March 6, 2002 22.26 25.83 -13.82 -11.00
NetBank (NTBK:Nasdaq) Feb. 6, 2002 9.87 13.45 -26.62 -6.45
Coastal Bancorp (CBSA:Nasdaq) Dec. 12, 2001 28.40 27.84 2.01 -2.04
FPIC Insurance (FPIC:Nasdaq) Nov. 14, 2001 11.82 12.83 -7.87 -5.82
Average Outlook
Innotrac (INOC:Nasdaq) June 12, 2002 $4.38 $4.79 -8.56% -23.43%
Champps Entertainment (CMPP:Nasdaq) May 29, 2002 10.34 13.01 -20.52 -5.57
Trico Marine (TMAR:Nasdaq) May 1, 2002 4.89 8.25 -40.73 -6.14
Rare Hospitality (RARE:Nasdaq) Feb. 20, 2002 21.70 25.72 -15.63 -5.41
SurModics (SRDX:Nasdaq) Dec. 19, 2001 20.64 34.60 -40.35 -2.23
VitalWorks (VWKS:Nasdaq) Nov. 21, 2001 6.34 4.30 47.44 -5.23
Coinstar (CSTR:Nasdaq) Nov. 7, 2001 26.73 19.96 33.92 1.10
Witness Systems (WITS:Nasdaq) Oct. 31, 2001 4.84 8.06 -39.95 -19.33
Hibbett Sports (HIBB:Nasdaq)** Oct. 24, 2001 17.47 20.04 -12.82 -19.68
Quixote (QUIX:Nasdaq) Oct. 3, 2001 14.86 21.44 -30.69 -15.95
Below Average Outlook
Wilsons Leather (WLSN:Nasdaq) May 22, 2002 $8.70 $14.96 -41.84 -22.18
Arch Chemicals (ARJ:NYSE) April 24, 2002 19.62 22.52 -12.88 -7.71
Hines Horticulture (HORT:Nasdaq) April 17, 2001 3.05 4.75 -35.79 0.00
Actrade (ACRT:Nasdaq) Jan. 30, 2002 2.06 20.65 -90.02 -40.12
Endocare (ENDO:Nasdaq) Jan. 23, 2002 11.28 18.21 -38.06 1.62
Quanta Systems (PWR:NYSE) Jan. 9, 2002 2.78 16.05 -82.68 2.96
Goody's Family Clothing (GDYS:Nasdaq) Nov. 28, 2001 3.45 4.50 -23.33 -44.08
Bridgford Foods (BRID:Nasdaq) Oct. 10, 2001 11.35 13.18 -13.88 -1.48
Bottom of the Barrel Income Portfolio
JDN Realty (JDN:NYSE) July 17, 2002 $11.14 $11.57 -3.72% -1.94%
UGI Corp (UGI:NYSE) June 26, 2002 27.75 31.30 -11.34 -10.19
Acadia Realty (AKR:NYSE) June 5, 2002 7.00 7.03 -0.43 -8.50
Capital Automotive REIT (CARS:Nasdaq) April 3, 2002 21.33 22.95 -7.06 -2.91
Laclede Group (LG:NYSE) March 20, 2002 19.94 23.64 -15.65 -7.69
Alexandria Real Estate (ARE:NYSE) Feb 13, 2002 40.33 40.25 0.20 -10.83
Empire District Electric (EDE:NYSE) Jan. 16, 2002 17.13 21.23 -19.31 -6.29
Integra Bancorp (IBNK:Nasdaq) Jan. 2, 2002 22.12 20.75 6.60 2.88
Met-Pro (MPR:NYSE) Oct. 17, 2001 12.99 11.16 16.40 -11.93
Bottom of the Barrel Special Situation Portfolio
Luby's (LUB:NYSE) Feb. 27, 2002 $5.80 $6.22 -6.75% -3.65%
*Average price on date of mention.
**Prices adjusted for 3:2 split on Feb. 20, 2002
Source: Thomson Financial/First Call, TSC Research

You can also find value in many of the income portfolio's names. As suggested in past missives, small-cap names with nice yields will outperform in times of trouble. Given relative returns, that has proved to be true in the past several months.

Next week, look for another addition to the portfolio and a review of second-quarter earnings.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm 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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