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Six small-cap stocks that may speed ahead as the economy slows

Michael Brush

Osterweis fund manager Jim Callinan expects stocks he owns to at least double

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Small-cap stocks are beating their bigger rivals.

The Russell 2000 Index (^RUT) is up 6.5% this year, compared with 2% for the S&P 500 Index (^GSPC) of large-cap stocks.

This outperformance makes sense for three reasons. First, small companies are leaner. So they benefit more than larger companies from inflation, which appears to be heating up. As lean machines, more of the extra revenue drops to the bottom line.

They also benefit from the strengthening dollar more than large companies do. Big companies get more earnings abroad. A stronger dollar diminishes those foreign earnings in the translation back home to U.S. dollars. Small, domestic companies don’t have that problem.

Small-cap investing maven Jim Callinan has his own theory on why small is beautiful — small-cap growth, that is.

“We may be going into a slow-growth five-year period. So growth will be more highly prized by investors,” says Callinan, who manages the Osterweis Emerging Opportunity Fund (OSTGX). “There are lot of ways for growth stocks to continue to do well in an economy that is moribund. I’m really bullish on small-cap growth.”

All other things being equal, you’re more likely to find high growth at small companies than big ones for a simple reason: Many large companies can’t grow as much because of their sheer size.

A cynic might say Callinan is talking his book as a small-cap manager. But he also might be worth listening to because of his record.

Callinan beat the Russell 2000 growth index by 3 percentage points annualized over the past three years, and 4 percentage points over the past five years. Those performance numbers are an amalgamation of his current and prior investment vehicles. But they’ve been prepared according to Securities and Exchange Commission rules.

Callinan also is worth listening to because he has lots of experience in this space. A Harvard Business School alum, he worked at two of the premier growth shops during the heady days of the late 1990s. He managed growth funds at Robertson Stephens and Putnam Investments back then. He was Morningstar’s manager of the year in 1999.

‘Anchor point’

What’s his trick for beating the market?

At the core of his approach, Callinan looks for an “anchor point.” By this, he means a “stretch goal” for some metric, such as customer or revenue growth, which a company suggests it can hit three to five years out. Callinan uses this as a basis for shaping long-term earnings estimates. Then he follows the progress at a company closely to make sure they are on track, and not switching their anchor point. That makes him nervous. His companies typically grow sales at around 30% a year. He expects a minimum of 100% upside on every stock he owns.

Beyond that, like a lot of money managers who outperform, he likes to take concentrated positions. He’ll usually hold about 25 stocks. The typical fund manager tries to own twice as many to reduce risk. “There just aren’t that may super-great companies that grow for a long time,” he says.

Here’s the low down on six of his favorite stocks.

Align Technology (ALGN

This company is on a mission to straighten out teeth around the world. It offers the popular Invisalign clear aligners, or braces, and a digital scanner called iTero, which speeds up the fitting and delivery of the aligner to dentists. Aligner sales grew 36.5% in the first quarter. Scanner sales grew 84%, but they are a much smaller portion of overall sales.

The company shipped 1.2 million Invisalign aligners in the trailing 12 months. Callinan thinks that will grow to four million a year over the next few years. Align is growing by expanding into the teen market, and also abroad — especially in China. It’s rolling out new products as well.

Inogen (INGN

Inogen is a baby-boomer play. It sells portable oxygen concentrators for people who need extra oxygen because they have chronic respiratory conditions. Those devices concentrate the air around a patient to offer supplemental oxygen. They’re designed to replace stationary oxygen concentrators and oxygen tanks. Tanks require tubes, and tanks run out. So new ones have to be delivered, which can be annoying. If you’ve ever waited for the “cable guy,” you know all about this.

The convenience factor helps explain why sales growth is robust. Revenue grew 51% in the first quarter, on 77% growth in the number of devices sold. Net income was up 83%.

Callinan thinks unit sales can grow to 500,000 a year, up from 128,000 last year. At $2,500 a pop, that suggests significant revenue growth. Inogen sold 45,400 units in the first quarter, up 77% from a year earlier. So it’s off to a good start. The company thinks 2018 sales will come in at $315 million, up 26%.

Planet Fitness (PLNT

Planet Fitness sells gym memberships. But it’s also a stealth Amazon.com (AMZN) play. Urban landscapes are now pockmarked by vacant store fronts. Intimidated by Amazon.com, retailers won’t move in. This opens up a lot of options for Planet Fitness, as it maps expansion.

Growth is already solid. Revenue grew 33% in the first quarter. Sales at gyms open for more than a year (which strips out the impact of new ones) increased 11.1%. That’s pretty decent expansion in a 2.5%-3% growth economy.

Why the robust growth? Memberships are cheap, and Planet Fitness offers a laid-back environment. “It is clear that our welcoming, non-intimidating environment and accessible price point is increasingly resonating with the casual and first-time gym user,” CEO Chris Rondeau said on the company’s first-quarter conference call.

He thinks the company can more than double its 1,565 store base to 4,000 outlets. That’s Callinan’s “anchor point.” Only 20% of the people in the U.S. have gym memberships, which leaves room for growth. There’s also opportunity in Canada and Mexico. And Callinan likes the prospects for getting more revenue out of members, by up-selling them premium services. “They haven’t even started to scratch the surface on adding to services,” he says.

Planet Fitness has over 1,000 gyms in the pipeline. About 600 will open over the next three years. The company expects 40% earnings growth this year on 20% sales growth, and same-store sales growth in the high single digits.

New Relic (NEWR

As companies put more business online and in the cloud, it’s getting tougher to understand what’s really going on behind the hodgepodge of software apps. New Relic helps them cut through the noise to figure it out.

Its software helps companies monitor their own software, catch developing problems, glean insights from data and understand what it feels like to be a customer. A key here is that the “New Relic Platform” is easy to use. “This software is uniquely useful as oppose to uniquely abstract,” says Callinan.

New Relic products are a hit, judging by sales trends. Revenue grew 35% in the most recent quarter, and the company expects the same growth in the year ahead. New Relic offerings get high marks from Gartner (IT), and they are integrated into Amazon Web Services, Microsoft’s (MSFT) Azure and the Google Cloud Platform from Alphabet (GOOG) (GOOGL).

Gartner estimates that only 5% of business software apps are tracked by monitoring software like New Relic’s products. New Relic CEO Lew Cirne thinks that will quadruple by 2021. He says that means his company has a “significant runway.” This is the “anchor point” framing the growth potential for Callinan.

Solaris Oilfield Infrastructure (SOI

This company helps energy producers manage the delivery of sand used in fracking, by offering specialized equipment and crews. They make sure enough sand is on hand, and at the right time, so workers and expensive rented equipment don’t have to wait around. Sales grew 43% sequentially in the first quarter and 249% year-over-year. That qualifies as solid growth in anyone’s book.

But Solaris’ “anchor point” suggests a lot more to come. The company supported 25% of the fracking rigs in the country in the first quarter, and it projects it can increase that to 41% by the end of the year, according to Hodges Capital Management energy analyst Mike Breard.

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter, Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.



Michael Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group. He attended Columbia Business School in the Knight-Bagehot program.



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