Tighter rules may work to small-caps' advantage

The Insider

Your Money

April 24, 2005|By BILL BARNHART

Auto painting specialist Earl Scheib Inc. says it's a victim of the "ups and extras" it promises never to charge its customers. This month, the company withdrew its stock from public trading and ceased filing reports with the Securities and Exchange Commission.

"We are burdened with increasing costs inherent not only to us, but to public companies in general," Chris Bement, chief executive, said in a statement. "We believe these costs, particularly in light of the Sarbanes-Oxley Act of 2002, will only continue to increase."

Sarbanes-Oxley, a congressional reform of corporate governance enacted in the wake of accounting scandals at giant companies, including Enron and WorldCom, has fallen heavily on small public companies. Among its provisions, companies must install rigorous financial accounting and auditing controls.

A survey of companies by the Nasdaq stock market found that small companies, those with annual revenue of less than $100 million, faced average compliance costs of $535,380. As a percentage of revenue, the amount was 11 times more than large companies faced.

"There's no question that Sarbanes-Oxley has been an impediment to companies going public," said Paul Purcell, chief executive officer of investment banker Robert W. Baird & Co..

But investors in the smallest of small-company stocks, sometimes called micro-caps, need to think dispassionately about the costs and benefits of a law made to restore their confidence.

As always, there are two sides to the story.

Gerald Perritt, a veteran small-cap stock picker, said investors have a simple way to guard against corporate misfeasance. It's called diversification.

"If I own 500 companies, I've diversified away the risk of getting one bad egg," he said. "But each of the 500 companies pays the Sarbanes-Oxley cost. Is the cure worse than the disease?"

On the other hand, Sarbanes-Oxley could extend the rally in small-cap stocks that by most accounts is looking tired after five years. There's nothing like a costly new regulation from Uncle Sam to shake up the status quo.

Michael Crowe, a small-cap portfolio manager at Mesirow Financial, said the urge among small-company managers to escape Sarbanes-Oxley hassles could provide a fresh lift to share prices of companies in his portfolio that decide to go private through acquisition by other businesses or private equity firms. "Assuming they take it private with some kind of price premium, I only hope we got there first," he said.

In a different vein, micro-cap companies that seek private equity capital rather than initial public offerings will have Sarbanes-Oxley-compliant financial controls installed rapidly, as the private equity firms upgrade their companies for eventual resale to public investors, said David Coolidge, vice chairman of investment banker William Blair & Co. "The higher valuations that the public markets can offer can overcome all these obstacles," he said. "Valuations drive decisions more than the hassle factor."

In any case, small companies and their investors will have to grow up faster, said Michael Kollender, executive vice president of investment banker Ryan Beck & Co.

"The glory of being public for the sake of being public is not here."

That's good news for investors.

Bill Barnhart is a columnist for the Chicago Tribune, a Tribune Co. newspaper. E-mail him at yourmoneytribune.com.

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