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June 23, 2005
Panning for Gold: Principle Profits Applies Socially Responsible Investing to Microcaps
    by William Baue

Massachusetts firm examines financial, social, and environmental performance to identify future winners.

Socially responsible investment (SRI) tends to focus on large capitalization companies, those that exert the biggest influence on society and the environment and hence worthy of supporting for their responsible behavior and reforming their irresponsible practices. There are significantly fewer mid- and small-cap SRI opportunities. When it comes to microcaps (companies with $500 million in market capitalization or less), arguably of equal importance as incubators of the next generation of corporate practice, there is a relative void in the SRI community. One exception is Amherst, Massachusetts-based Principle Profits Asset Management.

"I don't know of any of socially responsible microcap manager," said Dan McKenna, Principle Profits' portfolio manager, who founded the firm in 1992. "To me, microcaps are the most interesting and underserved part of the market--I don't know why anyone would need me to tell them to invest in Intel."

Of course Intel (ticker: INTC), which is included in many SRI portfolios, was once a microcap. Founded as Integrated Electronics in 1971 by Hungarian immigrant Andrós Króf (who later Americanized his name to Andy Grove), the company went on to generate profits characterized by the Motley Fool as the "largest legal creation of wealth in history."

"It's like panning for gold in a way," Mr. McKenna told "Of the 16,000 publicly-traded stocks, there are thousands and thousands of tiny companies on the margins of the investment world where that whole efficient market theory just doesn't work--not all information is known by all people at all times, so there's a lot of inefficiency in pricing."

"You get on the bus sometimes and you have to wait a while for the market to catch up with your 'brilliance,'" he added.

To identify microcaps that exhibit "GaaRP" ("Growth at a Reasonable Price") characteristics, Mr. McKenna applies the proprietary ten-point "Principle Profits Ranking" system. This system examines traditional factors such as price-to-earnings and price-to-book-value ratios, return on equity, and cash flow, ranking companies on a scale from 0.0 to 10.0, with 6.5 as the minimum threshold for investment consideration.

Principle Profits then conducts a social issues assessment, grading companies from A+ to F, with a B grade as the minimum threshold to qualify for the investment universe. While most SRI asset managers purchase information about corporate social and environmental performance from SRI research firms, microcap SRI research is as scarce as microcap SRI asset management.

"We do all our own tire-kicking," said Mr. McKenna. Principle Profits employs anywhere from four to eight interns every semester who help with social issues research, sending out questionnaires on social and environmental issues to each microcap considered for investment, following up with telephone interviews. "We try to talk to as many of the management teams as possible."

The Principle Profits team also conducts web-based research, which has its own challenges.

"If you Google Intel, you get 8,000 hits; you Google Mity Lite [MITY and you might get four," Mr. McKenna points out.

Interestingly, Mr. McKenna considers it more difficult to identify socially responsible large-caps than socially responsible microcaps. To illustrate his point, he draws an analogy to children and adults

"Microcaps are like children--they're young and small and haven't had a chance to grow up and get corrupted yet--they have maybe 250 employees instead 25,000, they're usually very focused on a particular product or service instead of ten different divisions each with nine different things going on," he explained. "You don't find a lot of microcaps in the big uglies--the defense industry, oil, chemicals."

Instead, microcaps tend to focus on market opportunities that are socially and environmentally beneficial, or at least benign.

"We invest in a lot of alternative energy companies, solar companies, fuel cell companies, companies that are producing biomedicals," Mr. McKenna said.

For example, Nature's Sunshine (NATR) is a Provo, Utah-based company with a $250 million market capitalization currently trading at about $17 a share that produces vitamins, biomedicines, and nutria-ceuticals.

"Nature’s Sunshine passes all the negative screens--they're not in nukes or weapons--and on the positive side, they are creating employment opportunities for people wanting to become their own employer, distributing products that are natural and healthy," said Mr. McKenna.

While the majority of Principle Profits' clients are high net-worth individuals (typically Generation Xers inheriting money from Baby Boomers), the firm seeks to expand its reach in microcap expertise to a broader client base.

"Our intermediate-term goal is to open a socially responsible microcap mutual fund," said Mr. McKenna.


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