Salomon finds almost 100 small cap convertibles expected to lead 2002 rebound

By Ronda Fears

Nashville, Tenn., Jan. 9 - Assuming the recession ends sometime in 2002, Salomon Smith Barney convertible analyst Adrian Miller went in search of stocks and related convertibles that may lead the way into the next bull market. In a report Wednesday, he identified nearly 100 convertibles. At year-end, the small cap convertible segment represented 9.5% of the convertible market, on a market weighted basis, the analyst said, noting that the group accounted for 12.3% of the market weight at year-end 2000.

"Going forward, if small-cap stocks perform as expected, the convertible market cannot help but benefit from this performance trend," Miller said in the report.

"Not only should we see more small cap companies coming to the new issue convertible market but also those currently outstanding should experience strong upward momentum."

Salomon Smith Barney's small-cap stock strategist, Bill Julian, believes small-cap stocks should lead the way in 2002 in part because small-caps have outperformed large-caps in all of last the last five recession recoveries, the report noted.

The report added that wide bond yield spreads and still-high volatility are typical of the tail end of recessions and contribute to the valuation gap between large and small stock. Another point is that growth stocks should outperform value stocks at least through the first half of the year at which time value will then assume the role as the dominate performer.

The Salomon strategist said growth has outperformed value in 10 of the last 11 recessions recoveries and a repeat of history appears all the more likely because of the dominance of technology in the Russell 2000 growth index. The strategist expects the rebound period will start this summer, once it is clear that the recession is behind us, and once the market shift its focus away from liquidity drivers to earnings results.

Miller said another point of interest is to try to identify which sectors look the most attractive and will likely lead the charge during 2002. Of the 11 industry groups represented in convertibles, the Salomon analyst believes technology, consumer cyclical, healthcare and financials should offer the leadership needed to propel the small-cap group going forward.

The shrinking representation of small caps in convertibles, the analysts said, is due to improving and performing companies growing their way out of the small-cap category even in the face of rising new issues.

"While small-cap convertibles was the better performing group within the convertible market in 2001, they did not outperform small-cap stocks, as represented by the S&P 600. However, the traditional defensive characteristics found within convertibles did supply protection during those months when small-cap stocks took it on the chin," Miller said in the report.

"Needless to say, with the small-cap indices out performing their larger cap cousins in 2001, convertibles associated with this class of equities were positioned to post superior results."

In order to list convertible issues within the small cap group, Miller screened the U.S. domestic convertible universe looking for issues whose underlying market cap is between $200 million and $1 billion, stopping at $200 million with the idea to avoid many problem issues that may not be expected to recover in the near future.

Convertible issues whose quantitative characteristics are such that it would afford convertible investors attractive upside participation in the event these stocks do well in 2002, according to the Salomon report, include American Greetings, Brooks Automation, EGL, Electro Scientific, Genesco, Hutchinson Technology, Kulicke & Soffa Industries, NCO Group, NRG Energy, Profit Recovery Group, RadiSys, School Specialty, Texas Industries and Waste Connections. There were about 40 in all.

Convertibles that exhibit more of a fixed income slant, or busted convertibles, which may benefit from stated and/or implied credit spread contraction in the event their respective stocks demonstrate improved fundamentals thereby driving stock performance included Aether Systems, Alpharma, Briggs & Stratton, Curagen, Dupont Photomasks, Emcore, Fleming, Foster Wheeler, GlobeSpan, Meristar Hospitality, NTL, ONI Systems, Parker Drilling, Quanta Services, Redback Networks, Shaw Group, Terayon Communications, TranSwitch and Viropharma. There were about 52 in all.

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