Source: LOHAS Weekly Newsletter
Published: Monday, November 01, 1999

NEW YORK—The crash of natural products stocks that began in August 1998 and the lack of any substantial rebound during the past year have left many analysts, investors and industry executives wondering, “How can an industry with such long-term growth fundamentals have underperformed the major stock market averages?”

Could it be that the relatively small size of most natural products companies, in terms of market capitalization, is a primary reason why their stock prices have been suffering during the past year?

The majority of companies in the Natural Business Composite Index™ (NBCI) have very small market capitalization figures. Only two companies, Whole Foods Market (WFMI) and Rexall Sundown (RXSD), have market values above $500 million. And with the pending sale of Worthington Foods (WFDS) to Kellogg (see related story, pg. 1), the recent purchase of General Nutrition Cos. by Dutch-based Royal Numico (NUTV), and the proposed management buyout of Herbalife (HERBA, HERBB), some of the heretofore largest companies in the index probably will be removed from the NBCI.

Given the above, the question becomes: Is it really informative to compare the performance of the NBCI to the performance of various stock market indices such as the Russell 2000? In our opinion, the answer is no, because, among other reasons, the typical company in the Russell 2000 is significantly larger than most natural products companies.

Until now, most analysts and industry experts have used this index as a method of industry comparison and have ignored the Micro Cap 1000 index.

The Micro Cap 1000 encompasses companies with market capitalizations below $500 million, which is a level more typical of natural products companies. In fact, 11 natural products companies are included in the index.

The average company in the Micro Cap 1000 has a market cap of $225 million, which is still significantly higher than the average natural products company capitalization of $105 million.

How does the Micro Cap 1000 index compare in performance to other mass-market indices? The perception in the financial world over the last several decades is that small-cap stocks have much greater returns than the larger company stocks that make up the S&P 500 and the Dow Jones Industrial Average.

However, an examination of relative performance over the past three years reveals a different story. From the accompanying chart it can be seen that the S&P 500 and Dow Jones Industrial indices have shown significantly better performance than the Micro Cap 1000. The Nasdaq index has had even higher returns, and the often-used Russell 2000 also has substantially outperformed the Micro Cap 1000. Of the 11 natural products companies that are in the Micro Cap 1000, only four have outperformed the index.

What will it take for either the NBCI or natural products companies to perform in the stock market at levels equivalent to the major indices? Smaller companies are generally not as liquid as their larger counterparts and therefore are much more volatile. As a result, investors’ concerns regarding company size generally are well-founded. For example, does the company have the ability to maintain and grow market share despite increasing competition from mainstream companies? Does the company optimize its debt-to-equity ratio in order to maintain growth and avoid bankruptcy? Does current management have the ability and sophistication to lead the company to the next level?

The answers to these questions are, as of yet, unclear, but there are positive signs. Consumer awareness and use of natural products are growing daily throughout the U.S. Industry growth remains a healthy 12% to 15% per year, despite a slight drop from before the crash. Some companies are bringing in professional management from the mainstream to assist in pursuing growth opportunities. Most importantly, industry consolidation is increasing so that companies can create operational efficiencies, increase profitability and create new opportunities to raise capital.

What else can be done by entrepreneurs in natural products-industry public companies, or, for that matter, by those in private companies? Industry insiders and company executives must focus on tackling the issues that investors consider most important for small companies. They must improve marketing and sales management in order to take advantage of the broadening of distribution channels such as mainstream grocery and pharmacy chains as well as e-commerce.

They must also continue to develop innovative products. Finally, industry entrepreneurs must begin to critically assess the necessity of either growing via acquisition or joint venture, or becoming a merger or acquisition target themselves.

Companies such as Hain Food Group (HAIN), Wild Oats Markets (OATS), Celestial Seasonings (CTEA), and Horizon Organic Dairy (HCOW) all are under $500 million in market value, are returning well above the Micro Cap 1000 and have business models that should lead to continued marketplace gains. The management teams of these companies embody the fundamentals mentioned above.

Considering all the above leads one to be optimistic about the stock market prospects of the companies that successfully meet the considerable competitive challenges. For stock pickers, the challenge, as ever, is to be able to separate the winners from the losers.

Chuck Slotkin is president of and Alan Jaffe is an associate with Nature’s Equity Inc., a New York-based investment banking and business development firm. Call 212.580.1666, or e-mail info@naturequity.com, for information.