Scanning the OTC market for new tulips

Dow down in the dumps? Bond yields ain't what they used to be? Consider planting a few assets in a garden-variety over-the-counter company. It'll take some digging. But you'll be in good company.

Last week, the Dow Jones industrial average meandered around as oil prices edged up, tax reform bounced back, and the economy continued to waffle. Ultimately, the Dow chalked up 14.75 points, closing at 1,789.43 on Friday.

Not a bad week. But the Dow has retreated back from its high of 1,855. Meanwhile, secondary stocks are moving closer to breaking through the topsoil.

The NASDAQ industrial average is slightly below its 1983 high of 408, whereas the Dow has long since shattered old highs hit in 1983, adding 45 percent to its total.

Now the OTC issues are gaining ground. Last month, Standard & Poor's 500 rose 1.4 percent. The NASDAQ industrials grew 6.7 percent.

``The OTC industrials have a lot of catching up to do,'' says Louis G. Navellier, editor of OTC Insights, a top-performing newsletter based in El Cerrito, Calif. ``I think they'll break into new high ground this month. Technically, they're much stronger than the S&P 500.''

Mr. Navellier considers 510 on the NASDAQ industrial average a ``very realistic'' goal for next February or March. He also consults for pension and mutual fund managers and has noticed that ``a larger portion of the new money they're getting is going into the OTC market now.''

Indeed, a Salomon Brothers report shows that some $500 million in new money -- much of it institutional -- has gone into OTC stocks this year. But the OTC shift did not just begin this year.

A study of trading from 1979 to June 1985 done by the Wharton School of the University of Pennsylvania shows that institutional investors are increasing their exposure to secondary stocks while decreasing their holdings in New York Stock Exchange issues. OTC-listed banks and insurance companies were the most popular among institutional investors.

Why is Wall Street increasingly enamored of small companies?

Historic precedent: A secondary stock rally tends to follow on the heels of a primary rally.

Economic conditions: In a moderate or sluggish period, earnings of large companies tend to mirror the economy, whereas small companies, with innovative products or special niches, may grow regardless of the economic environment.

Small companies grow with greater ease. A 30 percent gain in earnings is not readily attained by a larger company, because it's starting from a bigger base. For instance, for IBM's revenues to grow about 12 percent would require some $6 billion in new sales. That's equal to the entire annual sales of Sperry or Burroughs or Digital Equipment.

Then there's the ``small-company effect,'' which has been catching the attention of more and more investors. A recent Ibbotson Associates study reprinted in a newsletter put out by David L. Babson & Co., a Boston investment advisory firm, provides data for the OTC case.

It compares the performance of the smallest 20 percent of the New York Stock Exchange with the S&P 500 from 1925 through 1985.

The result: One buck invested in NYSE small stocks in 1925 would be worth $1,241 (including total dividends received) at the end of '85. But a dollar in the S&P 500 stocks would have returned a mere $279.

Of course, there's often more risk in OTC issues. A small company may depend precariously on one product, or one person, and not have the capital to withstand a lawsuit or aggressive competition from a larger player.

To cash in on all that tantalizing potential growth, one has to sort the wheat from the weeds.

Leighton McIlvaine spends most of his waking hours sorting through such pint-size firms. He manages the Neuwirth Fund, part of the Wood, Struthers & Winthrop no-load mutual fund family. And he's done quite well.

Last quarter the fund jumped 23.6 percent, vs. a 17 percent gain in the Dow. Over the last year, Neuwirth performance ranks in the top 10 percent of all equity funds tracked by Lipper Analytical Services.

By putting a premium on ``value,'' Mr. McIlvaine reduces the risk inherent in smaller issues. The value approach focuses on such things as strong balance sheets, heavy cash flow, and a low price-to-earnings ratio.

While many emerging growth funds may seek out new technologies, McIlvaine keeps his exposure to ``special situations'' down to 10 to 20 percent. ``We're not a go-go fund or technology fund,'' he says.

``We want stocks selling at P/Es [price/earnings ratios] lower than 13 [the average P/E for the S&P 500], or selling at low P/Es relative to their industry group.''

He is not averse to buying Big Board or American Stock Exchange issues, but they are so well covered by institutional players that it's harder to find undervalued stocks.

``The odds improve when you get off the beaten path and into the woods of the NASDAQ market,'' McIlvaine says.

Low prices and patience are also hallmarks of the OTC value approach. For instance, almost two years ago, he bought stock in Goody Products, a maker of hair-care items -- at $9 a share. Today, it's trading at about $26, and, based on earnings estmates, McIlvaine thinks it may go to $30. But he's starting to trim his holdings.

But the Neuwirth fund hasn't cornered the market on obscure but solid OTC investments. One favorite of Merrill Lynch's Larry Rader is Shelby Williams.

``It's the largest manufacturer of seating for hotels, motels, and restaurants. And there are thousands of hotels and motel franchises that must refurbish.''

Mr. Rader says the large hotel chains all signed large numbers of franchisees to 16- or 17-year contracts back in 1967-72. As those contracts come up for renewal, he says, the franchisees must refurbish their premises.