Interesting article on small caps.
pathfinder.com
November, 1998
The best buy in 20 years
Small-cap stocks offer better earnings growth prospects than blue chips but are selling at the lowest relative valuations since the 1970s.
If you have any contrarian instincts this is the ideal moment to profit from one of today's biggest bargains. Battered by this summer's brutal sell-off, the stocks of small growth companies are now incredibly cheap. And contrary to the normal pattern, they are actually better deals than small value stocks are. Small growth stocks are so undervalued, in fact, that they stand a good chance of outperforming blue chips when the market begins its next major advance.
The recent sell-off hit the smallest companies' shares the hardest. Stocks with market capitalizations of less than $250 million are down more than 50% from their highs of the past year.
Small- and midcap stocks have been getting hammered this way for a while. The infatuation with index funds, particularly on the part of 401(k) investors, has automatically been steering money into the biggest stocks. That has been compounded recently by a flight to quality as investors who are worried about the economic outlook focus on the most popular issues.
Historically, broad sell-offs have been followed by snappy rebounds. On six occasions since 1970 (including this past summer), the number of weekly new lows on the New York Stock Exchange ballooned to more than 40% of the total number of issues traded. The first five cases were in 1970, 1974, 1980, 1987 and 1990. In each instance, the ensuing rebounds continued for more than a year.
The case for small growth stocks does rest on one crucial assumption. Little stocks are inevitably more vulnerable in a bear market than blue chips are. So you have to believe the bull market isn't over. Odds are, that's correct--and the Dow could rally to a new high within the next year or two. Here's why:
Both short- and long-term interest rates have fallen by more than half a percentage point since July, helped by the Fed's recent rate cut. Lower rates typically improve the stock market's performance. Also, investors have largely recognized companies' earnings disappointments. Unless the next few quarters' earnings reports are far, far worse than expected, soft profits probably wouldn't drive stock prices below their summer lows.
Interest rates and earnings are the most important factors for stocks, but what about foreign financial turmoil and the Clinton scandals--could they undercut share prices? Again, only if the bad news is much worse than what's already expected. Japan's problems are well known, and emerging markets simply aren't big enough to rock this country's stocks. As long as the U.S. and European economies avoid recession, the global picture isn't bad.
Washington scandals don't affect stocks much unless the economy is in trouble. It's tempting right now to make analogies to the Nixon era, but the awful 1973-74 bear market had more to do with high inflation and interest rates than with high crimes and misdemeanors. In short, the market sell-off this summer was sharp enough to anticipate everything short of global recession.
When the next market advance does begin, many analysts think small growth stocks will shine. "Over the next two or three years, small growth stocks could deliver earnings gains of 16% to 20% annually, compared with flat to low single digits for the S&P 500," says L. Keith Mullins, emerging growth stock analyst at Salomon Smith Barney. Meanwhile, the group is greatly underowned, Mullins adds. Fewer than a quarter of the mutual funds that have made substantial investments in small growth stocks in the past have big stakes today. Any improvement in the little stocks' performance would likely encourage buying by portfolio managers that would quickly boost share prices.
History supports that view. "In nine out of 10 of the worst periods for the Russell 2000 over the past 20 years, the small-cap sector has gone on to outperform the S&P 500 over the following six months," says Claudia E. Mott, small-cap quantitative analyst at Prudential Securities.
Given this outlook, you might naturally think that value stocks would be the best deals among small-company equities. That's generally been true for the past three years, according to data compiled by the Leuthold Group. But the summer sell-off hit small growth stocks so hard that they lost more than 25% in August, compared with declines of less than 11% for small value stocks. That created the anomaly that the stocks with the best growth prospects are the cheapest.
Since it's tricky selecting individual small stocks (and you may need as many as 30 in order to be well diversified), most individual investors would be smart to choose a mutual fund that specializes in small growth stocks, such as Berger Small Company Growth (BESCX) ($2,000 minimum investment; 800-333-1001) or Brazos/JMIC Small Cap Growth (BJSCX) ($10,000 minimum; 800-426-9157).
Don't expect the window of opportunity to stay open for long, though. Many mutual funds realized capital gains this year. And if those funds still own any depressed small stocks, they will be tempted to sell them to generate tax losses. So will some individual shareholders.
This tax selling could hold prices down in the short run but will be almost entirely over by November.
So the January effect (the rebound in depressed stocks after tax-selling ends) could start early.
Investors who wait until Thanksgiving to buy small stocks may arrive late to the party.
italics mine. |
