** Small Caps **
Politicians on the other side of the aisle insist there's nothing wrong with President Clinton - that a change of jobs wouldn't cure. Some investors have reserved the same faint praise for their small stock fund manager.
Even in a market in which most stock sectors have capsized, small-stock funds managed to underperform all but emerging market funds, according to Lipper Analytical Services. The 4.9% average decline for diversified U.S. funds in the first nine months of '98 amounts to loose change against the 17% drop for small- stock funds.
Before ousting your incumbent manager, however, consider the terrain: Though the S&P 500 is 11% below its July 17 peak, the Russell 2000 small-stock index has fallen 32% from its April 21 high. A web of influences, both technical (supply-demand) and perceptual (indiscriminate selling of healthy and wounded companies alike) have contributed to the treacherous small-stock environment.
Weakening corporate profits and unstable global markets have driven fund managers into larger, more liquid stocks that can readily absorb big pools of cash without a run-up in the share price. Adding insult to injury, the specter of heavier-than- usual tax-related sales of battered small caps, to offset earlier gains in other stocks, has plagued the sector.
Still, for months, a chorus of sober voices has contended that small stocks, those with market values below $1 billion, are ripe for a turnaround. Small-stock advocates invoke the holy grail of ''fundamentals,'' implying that the market is undervaluing small caps, relative to their earnings and assets. Such thinking goes hand in glove with the idea of efficient markets which says: Hang in there. The market eventually rewards patient investors by assigning stocks the price they deserve.
For the first time in years, the average P- E ratio of stocks in small-cap funds has slipped below that of stocks in large-cap funds. As of Aug. 30, the average small stock P-E was 22.7, vs. 26.6% for large stocks, according to Morningstar Inc.
So instead of the ''premium'' investors historically have been willing to pay for small stocks' better earnings growth prospects, investors now value small caps at a ''discount'' to larger stocks. At the same time, small companies have posted superior earnings gains since the 1997 first quarter.
Satya Pradhuman, Merrill Lynch's director of small-stock research, says the earnings picture for small stocks is more clouded than many think. Since midyear, though results have weakened for large and small companies, the numbers have been poorer for smaller firms. Pradhuman expects more of the same as third-quarter earnings reports come in. He notes another interim hurdle: A looming credit crunch probably will penalize small firms disproportionately, especially those that depend on outside funds for growth or acquisitions.
More Vulnerable
What about the prevailing wisdom that large companies are more vulnerable to events abroad, because they rely more heavily on foreign markets to sustain their growth?
Pradhuman believes for now, the opposite is true. Larger firms have more wiggle room to control when bad news hits the bottom line. But in coming quarters, these companies will have to own up to the long-range impact of weak overseas demand.
What's left to do?
If you're a portfolio manager, you can change your job description. Many small-cap managers have shifted a portion of fund assets into better performing larger-caps, to prop up results and stave off redemptions. This strategy may make performance problems worse.
The virtue of holding small stocks, investors have been reassured, is that they outperform big caps over the long haul. But the best known studies cited to support this view, by Chicago-based Ibbotson Associates, define small stocks differently than most funds do.
Drifting Definitions
What qualifies as small cap in Ibbotson research would be termed a micro cap today: The market value of the largest firm in Ibbotson's ''small stock'' group was just $261 million, as of September '97.
Call it style drift or bull-market-bracket creep, but the average market cap of stocks in small-cap funds tracked by Morningstar was $662 million on Aug. 30, after the recent plunge in market values.
From '26 through '97, small stocks (the lowest fifth, by market cap, of NYSE stocks) appreciated by about 13% a year, vs. 10.7% for all stocks. Ibbotson's small caps, stocks under $945 million, advanced 12.2%. Mid-caps, those less than $1.3 billion, grew by 11.9%. Smaller stocks have been high achievers, but micro caps have been the stars.
Kathy O'Connor, co-manager with Wesley McCain of Eclipse Equity, has done well by, among other things, staying true to the fund's small-stock value mandate. Though Eclipse buys stocks with market values up to $2 billion, the portfolio median cap is about $375 million.
During the last quarter, Eclipse shifted its emphasis away from consumer-oriented industries, toward hard-hit industrials. O'Connor likes steelmaker LTV, and Gencor Industries, a producer of heavy machinery, despite their near-term cyclical exposure.
Eclipse focuses on components of performance, such as asset turns and margins, so the fund often spots turnarounds before the improvement shows up in the bottom line.
If small stocks account for a lower percentage of your portfolio than you intended, bear in mind: Small caps usually are the first out of the gate when the economy recovers. |
