Why small-caps are still suffering
The answer, in many cases, is liquidity - but analysts say the situation
will change soon
Part one of a two-part special report
By Michael Brush
moneydaily.com
Small-cap stocks rallied Thursday as the Russell 2000 Index tacked on
better than a half a percent to close at 451.74. But by any measure,
these small fry are still in the dumps.
Indeed, investors have been hammering small-cap stocks so badly in the
past month that they're at levels not seen since the bleak days of last
two major market corrections in 1990 and 1987, if you measure by
trailing price-earnings ratios.
As of Tuesday, the average NASDAQ stock was 30% off its twelve-month
high. "There is a lot of blood in the market," notes John Manley, the
chief equity strategist at Salomon Smith Barney.
All this seems odd, if you consider that small-cap stocks -- typically
defined as those with a market cap of $1 billion or less -- offer
decidedly stronger earnings growth than their larger counterparts.
"Small-cap stocks have their best growth to price-earnings ratio since
1990, while big-cap stocks are grossly overvalued," says Louis Navellier
of Navellier & Associates, which runs several small-cap funds.
Need some numbers? Consider these. The Russell 2000, a common small-cap
index, is priced at about 19 times forward earnings -- earnings that are
expected to grow about 20.6% in the next twelve months, points out
Navellier. The S&P 500, meanwhile, is trading at 22 times forward
earnings, even though those earnings are only expected to grow by a much
lower 10.2% over the next year.
The faster growth of smaller companies is not unusual. They typically
grow more quickly, in part because they are starting from a smaller
base. Sell two units instead of one, and you have 100% growth. And right
now, they have the added advantage of less foreign exposure, meaning
they probably won't be hurt as much by Asia or the strong dollar.
Despite these advantages of faster growth, valuations near historic
lows, and less foreign exposure, investors these days still look at
small-cap stocks as if they were real estate next to Chernobyl, says L.
Keith Mullins, a small-cap stock analyst at Salomon Smith Barney. Cheap,
yes. But no one wants it.
Why are investors paying so much more for large-caps when they're
getting less? It boils down to the deeper liquidity of larger stocks --
meaning that fund mangers can get in or out of them without moving
prices as much.
"The last place you want to be, in a world where there could be a crisis
at any moment is in an illiquid, small company," says James Paulsen, the
chief investment officer at Norwest Investment Management. In the last
decade, seasoned investors have seen crises sparked by Asia, Mexico,
derivatives, U.S. banks and war in the Middle East -- and they are wary
another problem could strike soon. They are also on tenterhooks because
of worries about the Fed raising rates or corporate earnings falling
short.
Investors know that getting out of the smaller stocks if another problem
breaks out means having to take a big loss -- since their liquidity is
so low. A little selling pressure drives their prices down dramatically.
Indeed, Paulsen thinks that if you adjust the higher growth of small-cap
stocks for their volatility, often used as a proxy for risk, then the
larger companies have a better risk-adjusted growth rates in the eyes of
many investors.
Another reason small-cap stocks are underperforming, points out
Prudential Securities small-cap stock analyst Claudia Mott, is that a
lot of the recent capital inflow to U.S. equities comes from foreign
investors, who tend to go for the big-cap names.
What's more, individual investors have been selling small-cap funds in
favor of bigger-cap funds. "This is unfortunate," says Mott. "Because
they are all going to be cleared out of their small-cap funds right as
those funds are about to rebound. It is rare that you see this kind of a
spread between small- and large-cap profits."
"The average investor is just chasing last year's performance and buying
the index funds," agrees Navellier. "But every major strategist is
saying: 'Small, small, small.' You just need something to spark them. I
am waiting and very patient."
For a review of some potential catalysts that might rekindle small-cap
stocks and give Navellier some company in the small-cap end of the
market, see tomorrow's Money Daily.
Send your comments to Michael Brush
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MarketwatchClosing numbers for
Thursday, June 4, 1998
(Click for latest figures)
Dow Jones Industrial Average:
ÿÿÿup 66.76 (0.76%) to 8870.56
Money 30 Index:
ÿÿÿup 33.16 (2.08%) to 1630.49
New York Stock Exchange
ÿÿÿAdvances: 1623
ÿÿÿDeclines: 1243
ÿÿÿVolume: 574 million shares
NASDAQ Composite:
ÿÿÿup 27.64 (1.59%) to 1769.95
S&P 500 Index:
ÿÿÿup 12.10 (1.12%) to 1094.83
Russell 2000:
ÿÿÿup 2.58 (0.57%) to 451.74
30-year Treasury bond yield:
ÿÿÿup 3 basis points to 5.81%
London gold (afternoon fix):
ÿÿÿup $0.40 to $292.80
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