J.M. Dutton & Associates

Financial Finds: Interview with Dutton & Associates' Richard W. West, CFA

Richard W. West, CFA, has a range of experience extending over 40 years in securities analysis and investment management. Following three years as a broker with Stein Bros. & Boyce, he moved into investment management and research in the early 1970's with Delaware Management. From 1974 to 1983, with Brittingham, Inc., his responsibilities included management of the U.S. portfolio of the Nobel Foundation, one of the premier growth portfolios of its time.

He formed an investment management and research firm in the mid-1980's specializing in small-cap growth stock analysis and investment publishing, following which he served as research director with Gaines Berland, an investment firm specializing primarily in growth stocks and special situations. He has been independently engaged since 1998 in corporate finance and private research activities.

How would you define your area of research focus?

I consider my focus to be on the smaller-capitalized companies. There is a distinction to covering smaller-company stocks that I find challenging and rewarding. The small cap analyst has to be willing to do a little more work than the average analyst covering large companies because nine times out of 10 the companies we're following in the small-cap area do not have other coverage.

What work does this involve?

Outside of the standard reviewing of all the 10Qs, SEC filings, annual reports, I find that visiting with management, talking to suppliers, and checking out the industry helps immensely with the small-cap companies. I talk to the people they do business with ' their suppliers, their lenders. I've got to have the ability to go through the smokescreen that management will put up from time to time in just noting the positive factors.

What experience do you have that assists you in this?

I cut my teeth on researching small-cap companies in the early 70s when I managed Delta Trend Fund for Delaware Management. I have focused on small caps ever since, most recently working for a regional retail brokerage firm as a research director recommending small-cap stocks for the retail brokers.

What areas do you focus on within the small-cap environment?

I try to focus on those companies in the small-cap world that are 'in trend.' with their earnings and revenues. I look for story stocks that have a good turnaround situation in place or companies that have turned that the corner and are showing momentum with their earnings and revenues. I try to stay away from the 'popular,' momentum-driven stocks that have already moved. I missed the 'DotCOM' companies on the way up and also missed their quick demise.

You most recently have covered a number of financial stocks.

With the trend in interest rates, the financial service companies have been attractive to me in the last 18 months. Recently, you've had to pick and choose because the big move in interest rates is mostly over ' it will be hard for the FRB to cut rates much lower than they are now. This is the time when the finance companies need to show their mettle and how well they're doing in growing their own business internally, taking advantage of swap, selecting good credit risks and creating their earnings from their environment with the interest rates.

You're looking for both growth and value?

That's right. I'm looking at story stocks that evidence value and momentum in revenues and earnings, like HPSC Inc. (AMEX: HDR), which meets both those criteria. HDR is an undervalued stock as far as book value to market cap, P/E ratio,, and the earnings momentum is definitely in place. With HDR both the value and earnings momentum are in place and when both of those are moving together we believe it could be quite positive for the price of the stock.

What does the company do?

HPSC has a niche marketplace -- it provides financing to health care parishioners. The healthcare market served by HPSC consists of more than ten different medical professionals including; internists, radiologists, OB/GYN doctors, ophthalmologists, dermatologists, dentists, chiropractors, cosmetic surgeons, veterinarians, orthopedists, and community health practitioners. Usually the equipment they're financing costs less than $300,000. They've done quite well in this market because the default rate on payments for that group of clients has been low. Doctors usually need the financed equipment to continue their practice and this factor provides a natural insulation from lower economic activity. The second and smaller portion of its business, conducted through its subsidiary, American Commercial Finance Corporation ("ACFC"), is the asset-based financing to commercial and industrial companies that generally could not readily obtain traditional bank financing. This area usually shows growth in revenues during slow economic times.

What other companies have you found interesting?

Another company we follow, Warrantech (OTCBB: WTEC), which services the warrantees for consumer products, is a very interesting situation. Warrantech falls into the category of undervalued story stock because historically, two to three years ago, it fell on bad times and has now recovered and began an earnings turnaround, but because of the marketplace and being listed on the bulletin board, this turnaround was not recognized, even though they do have the earnings growth.

The stock price has nearly tripled in the last six weeks after you initiated coverage.

Warrantech had a series of problems that management has solved. The latest problem was that their insurance underwriter, Reliance Insurance, was being liquidated, and Warrantech faced possible liability for 45% of the contracts they had administered for Reliance, because Reliance could not meet the payments of clients making claims on the warranty. The liability could have been quite large.

But after Warrantech announced that their current insurance underwriter would be taking over the liabilities, the stock turned around. About the same time, we published our report. So we can take some credit for getting the information out. In addition, their earnings are now being recognized and all the problems are behind them.

You seem to like companies with niche marketplaces.

That's right. Another one that fits that definition is TFC Enterprises (TFCE), in the auto financing area. They finance dealers that sell vehicles to servicemen on the East Coast. Specialty finance companies for the auto dealers that again have a niche market are quite interesting rather than, say, the bigger finance companies. For TFC Enterprises, the fact that the dealers sell vehicles to members of the armed services again somewhat insulates against failure to pay. The car owners being members of the armed forces can't skip on their payments as easily ' it's known where they can be found, and TFCE's experience with this type of financing has been good.

Do you look at brokerages?

I've looked at some of the brokerage firms but already there's been so much consolidation within the industry. There's one or two small brokerage firms that haven't been purchased that might be worthwhile to take a look out ' a Raymond James Financial (NYSE-RJF) is an example of a brokerage firm that may be attractive to a larger brokerage firm or bank. .

How about small banks?

There are some small independent banks that are like tulips in a flowerbed waiting to be picked by somebody. For example, First National Bank of Chester County and smaller banks like it that are doing quite well are just waiting for that takeover bid from a larger bank.

What do you see as the changes in research economics that have led to the decline in research coverage of small-cap companies?

I have seen the world of stock research change greatly over my years as an analyst. The biggest change in research coverage came with the beginning of negotiated rates in the mid-1980's. Before then, brokerage firms performed research on all levels of companies, large to small cap. Then in the early 1990's the corporate finance departments made their views known, and the analyst many time became a tool of the corporate finance department. This was exacerbated in the last three years and the highest paid analysts were those analysts that were responsible for bringing in corporate finance business. Also in the late 1990's the small retail brokerage firm with their focus on 'product' for retail brokers emphasized research on companies whose stock traded and resulted in trading commissions for the house and brokers. Currently, with the state of economics of brokerage firms, brokerage research departments are most limited in what can be covered. In addition, many firms have a minimum price of $5.00 and minimum market capitalization as criteria for coverage. Hence, many small cap companies that are not heavy traders and are listed on the NASDAQ Small Cap or do not need nor qualify for corporate finance opportunities became 'orphans.'

What is it about J.M. Dutton & Associates' charter and revenue model that appeals to you as an analyst?

Firstly, I believe that every company regardless of its size or where it trades that has what I perceive as positive fundamentals is entitled to research coverage. Having said that, I believe that the charter of J.M. Dutton & Associates gives every qualified company the ability to have research coverage. When a company enrolls in the research coverage program and pays the initial up-front fee, I am then free to do my job as an independent analyst to conduct the due diligence research and follow-up for the coming twelve months. If during that period fundamentals change toward the negative, I am free to honestly report and change my recommendation. I believe that analysts beholden to the corporate finance departments do not have that option. Now, my only axe to grind as an analyst at J.M. Dutton is I want to be right and recommend a stock that's going to do well and if it doesn't I want to have the freedom to recommend Sell or to drop coverage.

Secondly, the firm is operated like other top Wall Street research firms are run. The firm provides highly experienced analysts, not desiring to work for Wall Street's sell side firms, the structure to operate in an environment conducive to quality investment research that benefits investors and companies. Only its revenue model is different from the other top research firms, and this allows it to be effective in today's Wall Street environment where coverage and recommendations are driven by investment banking and commission considerations. It is one of the leading models that I expect to become much more prevalent in coming years.