Small caps boost B. Riley's growth.

Being a Wall Street contrarian has paid off for Bryant Riley.

Riley, chief executive of local brokerage firm B. Riley & Co., started the company eight years ago as a research boutique focusing on undervalued, small-cap stocks in California.

Over the years, it has developed a loyal following among money managers and hedge funds looking for low-priced stocks with the potential for big price increases.

Since its inception, B. Riley's model portfolio of small-cap stocks has posted a 40.2 percent annualized return, beating all the major indexes. That compares with a 7 percent return for the Russell 200 index, and between 5 percent and 6 percent each for the Dow Jones Industrial Average, the Nasdaq Composite Index and the Standard & Poor's 500.

"They find stocks that are cheap, they visit with the company and even pressure the company to do the right thing for shareholders," said Rich Todaro, vice president and portfolio manager at Kennedy Capital Management in St. Louis.

B. Riley was an early stock-picker of a number of well-known names that traded below $2 a share, including Santa Monica-based Stamps.com Inc., Ask Jeeves Inc. and Autobytel Inc.

Riley has found himself in hot water several times too.

In 2002, when Cadiz Inc. tried to secure a controversial agreement from the Metropolitan Water District, a B. Riley analyst maintained a "buy" rating on the stock even as shares plummeted when the deal fell through. Riley still owns some shares in a personal account.

The company also was fined $5,000 in 1997 by the Securities and Exchange Commission for lax record-keeping. Riley says the fine was a reflection of the company just starting out and being too small.

Riley, who grew up in Orange County, had worked as a market maker and institutional salesman at now-defunct Dabney Resnick--and, like many traders, learned on the job. He developed a philosophy of the market by seeing the inherent inefficiencies in small stocks because of their size.

The business was launched with $100,000, and as he put it, "a lot of luck."

"You eliminate a lot of institutional buyers because they can't take big positions in a small stock," he said. "So a lot of value is created from that."

The company, which now has 58 employees and is based in Westwood, got its start doing research on manufacturers but now issues reports on more than 80 small- to mid-cap firms throughout California. It will host its seventh annual investment conference in Las Vegas this month, where 100 companies will vie for the attention of money managers and hedge funds.

The company earns its money from processing the trades--typically 4 cents per share--that money managers and hedge funds make based on its research.

Riley still sees a valuation gap between liquid Blue Chip firms and illiquid small companies. He expects a major round of consolidations in the next few years because of the high costs of Sarbanes-Oxley legislation. He noted that one local company, Edelbrock Corp., went private and expects others may follow.

"A lot of the $250 million market cap companies will consolidate either by merging or getting bought out," he said. "For small caps, it's going to be a really good year."

Christopher Jarrous, senior vice president of research at MicroCapital LLC, a San Francisco-based hedge fund, said B. Riley helps fill the void left by the disappearance in 2001 of the "four horsemen"--Montgomery, Securities, Robertson Stephens. Hambrecht & Quist and Alex.Brown. (Each was purchased by a larger bank.)

The four San Francisco investment banks each had large research arms devoted to small- and mid-cap companies. With their demise, a small group stepped up to fill the niche.

"Now there are a few regional finns around the country that are the only place to go if you need to look at small caps," he said. Others include Needham & Co. in New York and Stephens Inc. in Little Rock, Ark..

In the past few years, a few other small firms have cropped up to fill the investment banking niche for smaller companies, including JMP Securities and Merriman Curhan Ford & Co., both in San Francisco. Locally, Roth Capital Partners also has been ramping up its investment banking business, largely by issuing PIPEs, or private investments in public equity.

Branching out

Initially, Riley avoided investment banking.

He says he wanted to avoid the conflict-of-interest issues that led to scandals at firms like Citigroup Inc.'s Salomon Smith Barney unit, where high-profile telecom analyst Jack Grubman allegedly issued positive research reports to win investment banking business.

But in 2003, B. Riley purchased a small Irvine investment bank where Bryant Riley once worked, L.H. Friend Weinress Frankson & Presson.

"We still regard ourselves as a research-leading firm because without good research, you don't have a business plan," he said. "But we have been very careful of the perception that we've changed to an investment banking firm, which isn't the case."

In the past two years, B. Riley has issued research on at least 150 companies, but has provided investment banking services for just two of those.

Meanwhile, the firm has lured several bankers away from local firms, including Seidler Cos., and now has 14 investment bankers who completed $140 million in deals last year.

P.J. Solit, a money manager at Potomac Capital Management in New York, a hedge fund focused on small-cap stocks, said the addition of investment banking to B. Riley's business isn't a huge concern.

"It's always cleaner to have no banking, but I think the model makes sense for firms that are research-focused and that get to know management," Solit said. "That's how they operate. It's not a deal a week, it's several times a year based on opportunities."