Small-Cap Device Companies: The Roach Motel of Investing

As the value of big company stocks soar, small-cap device stocks have become a pariah. Not only do big company stocks provide great returns, but big investors are beginning to value liquidity and to turn away from small company stocks because they provide no liquidity.

The difficulties small-cap device companies have had in the public stock market over the past few years have been bad enough. After the rush into IPOs in 1995-1996, small companies are finding that even the closest miss on an earnings estimate can make a stock price drop precipitously. The situation's getting bleaker: burned by the poor performance of the small cap stocks, big institutional investors are shying away from the fledgling public companies and erecting barriers to future investment.

Dan LeMaitre of SG Cowen Inc., a leading medical device analyst, says the market for small cap device stocks has never been worse. "The attitude [on the part of institutional investors] is ‘Just go away,'" he says. "It's been so painful for some of them to own small cap stocks, their attitude is, why bother with them? I can't tell you how bad it is."

LeMaitre plays both side: he covers both big-cap firms and small-cap players like Novoste Corp. , Biosite Diagnostics Inc. , and Symphonix Devices Inc. "When you cover 30 companies, you have the flexibility to talk about whatever the customer wants," he says. "If we walk into a customer and they don't want to talk about small cap companies, it's easy for us to do something different. If all they want to talk about is Abbott, J&J, and Becton Dickinson, we can do that."

And many do, because of a growing feeling of having been burned investing in small cap stocks. Some funds are implementing rules to keep them from being tempted by small companies. One of the Fidelity funds, for example, reportedly recently raised the threshold for investing in companies from a $1 billion market cap to $5 billion. Says one industry executive, "Buy-side guys are calling small-caps the Roach Motel of investing: you buy into them and you can't get out."

Sam Navarro, another leading analyst who covers device stocks for ING Baring Furman Selz, concedes "it's pretty ugly out there," but sees some hope. While buyers are, admittedly, focusing on big-cap names that offer liquidity, they're also searching for medium-cap companies that "are reasonably priced, have an attractive multiple, and, often, still have a good name." Navarro recently added two mid-cap companies to his coverage list: ENT instrument specialist Xomed Surgical Products Inc. and sleep apnea company ResMed Inc. Both have good, consistently growing revenues and earnings, and both are trading below their secular EPS growth rate, he says.

In fact, they're almost bargains: while big-cap companies like Guidant Corp. and Medtronic Inc. are trading at between 30 and 35 times earnings, the premium investors pay for their liquidity, a company like Xomed is trading at a P/E ratio closer to 24. Navarro argues mid-caps may be poised for a comeback or, as he puts it, "a re-valuation as investors look to the next tier down."

That's still little solace for the too numerous, illiquid small caps Their problems are getting worse as money continues to flood into mutual funds. Notes Navarro, "When mutual funds used to be $50-60 million, you could invest in some micro-caps and have an impact on the fund's valuation and performance. But today, the funds are $1-3 billion if not more. Says Navarro, "You do the same amount of homework with a big- or mid-cap that you do with a small-cap, yet you can buy as many shares as you want and it can have a real affect on your portfolio," he says.

The beginning of a new market cycle, a stock market correction that slowed the growth of big-cap stocks, would clearly help shrink the current investment gap between big- and small-cap companies. Even without a correction, though, some industry executives think small caps may become more attractive as investors begin to tire of paying a premium simply for liquidity and begin to look for bargains among the current under-appreciated stocks.

But others think that small-cap companies need to take matters into their own hands. Some industry analysts predict a wave of small-cap mergers, as companies seek to leverage investments in areas such as sales and marketing; to create large enough market positions to show up on the radar screen of ever larger, more consolidated buyers; and to increase their own share floats. The feeling among some executives: it's time for small-cap companies to check out of the Roach Motel.