[Small-Cap article in IBD]
Joe --
You may have seen this, but if not, it gives a ray of hope. From today's IBD:
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No doubt about it. Small-cap stocks have been in a major rut. But investors who've abandoned them altogether risk missing a powerful move when they eventually turn.
And Mark Bailey, a portfolio manager at small cap-oriented Wasatch Funds out of Salt Lake City, sees the springs coiling underneath the small-cap portfolios he helps run.
MAKING MONEY IN MUTUALS
To begin with, history is on his side. If you invested $1 in large-cap stocks back in 1925, the account would have increased to $1,400 by the end of last year. That's an average annual total return of 10.7%, according to Ibbotson Associates. That beat Treasury bonds and bills as well as inflation. But small-cap stocks did even better in the 71 years, compounding to $4,500. That's an annual return of 12.6%.
Why the outperformance? Over the long haul, smaller companies grow faster than large companies. A small company might be able to double earnings annually in its early years. It may have a new, advanced product everyone needs. But as the company succeeds, taking more market share, it runs into trouble finding new customers. It's harder to double sales from $1 billion than it is from $25 million.
And by the time a successful company's earnings slow, it's grown large, so it's no longer counted in the small-cap indexes.
Small companies have had a hard time keeping their earnings growing faster than large caps in the last 15 years. During that time, large caps have leaned down from being fat, bloated and inefficient. Along the way their profit margins have improved, bolstering the bottom line. Smaller companies, in contrast, have little fat to cut. So they couldn't benefit from restructuring the way large caps have.
But there is only so much earnings growth to be gained from layoffs, downsizing and spin-offs, notes Bailey, 41.
''It's not possible to ultimately shrink a company to greatness,'' he said.
As large-company margins reach their inevitable ceilings, profit growth will slow, leaving small caps to stand out once again, he says.
Wall Street analysts see small- stock earnings strengthening this year and for the next five years. The small fry are seen delivering an average growth rate of 36% this year, vs. 16% for the S&P 500 companies, according to IBES, which compiles analysts estimates. For the next five years, small-cap profits are seen growing 18%, vs. 12% for large caps.
As earnings of small companies jump ahead of those of big caps, small-stock prices should show similar increases.
''It is hard to say when exactly small-stock prices will follow suit, but it can be said with a great deal of certainty that if small-company earnings do in fact grow faster, they will eventually drive small-stock returns up faster as well,'' Bailey said.
Along with faster earnings growth, small caps also feature lower valuations. That has stemmed from the correction a year ago. Small caps have shown few signs of rebounding from that dip until recently.
''The combination of lagging stock prices and accelerating earnings is bringing the P-E of small stocks down to the same level as large stocks,'' Bailey said.
Small-stock P-Es usually are higher than large caps' because small caps' earnings usually grow faster.
''Only rarely is one able to buy small stocks without paying a premium,'' Bailey said. ''We are near the attractive lows of the '90s and a long way from the peaks in relative valuations of 1983.''
Wasatch Micro-Cap is up about 19% this year. The tiny companies in which it invests have a median market capitalization of about $157 million, according to Morningstar Inc. Market cap is stock price times shares outstanding.
The group's biggest fund, Wasatch Aggressive Growth, with $176 million in assets, is up 11%. The name belies the fact that this fund has as much money in value-oriented companies as in growth. Its medium market cap is $474 million.
Wasatch Growth, which is careful not buy companies with high P-Es, carries an A+ grade from IBD for its 36-month return of 93%. It's up 15% this year.
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