Small-Cap Showdown

Sometimes it hurts to be right. After largely avoiding the dot-com boom, Chief Investment Officer Mark Thompson and his colleagues at Riverbridge Partners, a financial advisory and investment firm in Minneapolis, paid the consequences in 1999, when institutional investors pulled their money out for perceived greener pastures. In the late '90s through 2000, Riverbridge institutional assets dwindled to $100 million from $800 million, but private individuals held firm and business grew to $200 million.

What went up also came way down. As institutions and individuals alike realized the folly—and pain—of the dot-com bubble, money began coming back to the company. Riverbridge's returns in its core all-capitalization portfolio and its small-capitalization funds outpaced those who placed bigger bets on Internet- and telecommunications-related ideas. Since then, institutional assets have topped $900 million, and the firm's individual portfolios now total $400 million.

{Q} Small-cap growth stocks were on a tear for the past couple of years, but have slowed down. What has prompted that?

{A} Small companies tend to have weaker balance sheets, so when the economy strengthens, perception of risk goes down, and you will get incremental new money into small companies. Coming out of the fear and terror of 2002, small-cap stocks were advantaged in 2003 through 2005 and into 2006 because the economy was coming back and lending standards diminished.

When you're in an economic environment that's tougher and you're fighting headwinds, there is safety and liquidity in larger companies with stronger balance sheets. I think we were in that classic period where we've had five easy years of 'risk doesn't exist' to now, where the volatility and worry of the subprime situation is taking us into a softer economic environment.

{Q} As the favoritism from smaller to larger shifts, is it toward any particular type of larger company?

{A} Yes, it's generally the larger growth-type companies, because they don't have the same economic sensitivity. While you would think growth is higher risk, a large, growing company tends to be able to borrow capital in tough times, so they can be in a position to acquire their competitors, using their balance sheet as a weapon: better terms to their customers and better prices. So they gain market share and they gain earnings power for the next cycle. I think we're in that period.

{Q} What effect has the mergers and acquisitions market had on small-cap stocks?

{A} The M&A world, starting in '05 and '06, had lots of buzz, lots of hype: Many, many companies were acquired, and then related businesses rose in sympathy of 'Who's next [to be acquired]?'. For the past 18 months, I think that has been a significant leg under stock moves and valuations. But now, the access to capital by these private equity firms has significantly diminished in the past eight months, and very dramatically in the last couple months.

{Q} Will all this lead to more strategic acquisitions—companies making acquisitions rather than the private equity firms doing it for purely financial reasons?

{A} Yes, but it will take five or six months for the selling entities to realize that the world is different, that they aren't going to get the prices they expected. I'll bet that by 2009, we'll be back in a healthy M&A environment, where it's the more strategic buyer acquiring distribution, customer lists, and technology and product-line extensions.

{Q} How does something like the subprime market affect a small-cap growth stock?

{A} It affects access to capital. A significant percentage of the subprime mortgages that have been let in the last year aren't any good, and they're scattered throughout collateralized debt obligations along with corporate debt, credit card debt, and other credits. So if you create that general fear of 'What do I own?' and 'How much subprime debt is in the security I bought?', it means there's less capital available for conventional commercial loans.