*** Small Cap Article ***
Small Caps Take Off!
For years smaller stocks miserably underperformed their big brothers. Now they're booming, and there's reason to think they'll keep it up.
Jeanne Lee
A curious feature of the late-1990s stock market has been the sharp divergence between prices of the largest stocks and those of the "small caps"--the companies with market capitalizations smaller than $1 billion. This two-tier phenomenon is eerily reminiscent of the early 1970s, when the big, highflying Nifty Fifty companies outraced the rest of the market up to unsustainable valuations before ultimately hitting the wall. Similarly, investors in the past couple of years couldn't get enough of the biggest and "best" names, no matter how expensive they got. But since the long bull run screeched to a stop in August, blind faith in big caps has dissipated, and maybe--just maybe--it's time for small stocks to soar. The main small-cap index--the Russell 2000--is suddenly up 20% since its low on Oct. 8, and there are good reasons to think it could keep rising. "For the first time in years, you can actually create a positive case for small caps," says Claudia Mott, director of small-cap research at Prudential Securities. It wouldn't be the first time, either: once the original Nifty Fifty gave it up a quarter-century ago, small caps enjoyed a glorious run from 1974 to 1978.
The little guys have been unreasonably beaten down for a long time now. The Russell 2000 small-cap index fell 37% from April 21 to Oct. 8 this year, deep into bear territory (which is defined as a drop of 20%). Measured from May 1996 to the low in October 1998, the Russell was down 12%, while the S&P 500 was up 47%.
What's odd about this is that small companies have been thriving. In fact, over the past five quarters their profit growth exceeded that of large companies. The main reason for their relative underperformance seems to be a combination of factors that has kept large caps unreasonably inflated. "In the last year and a half, the large-cap market has not been driven by good fundamentals and valuations but by demand-related factors," says Mott. Foreign investors, who love the American household names of the S&P 500 and eschew unknowns, increased their U.S. equity purchases by 400% in 1997. Domestic investors poured money into index funds, many of which are by definition large-cap. Even purportedly non-index fund managers were "closet indexing," keeping their portfolio weightings as close as possible to their hard-to-beat S&P 500 benchmark and thus staying away from small stocks. This self-reinforcing cycle kept spinning even though the fundamentals of the large caps started wearing down about 18 months ago.
But now that those seemingly endless 30% gains for the S&P 500 have stopped, investors are noticing what they've determinedly ignored for so long: small-cap valuations are at 20-year lows, and there are some great bargains out there.
The fact that the Fed is cutting interest rates bodes well for small stocks: Of the ten times since the 1950s that the Fed has eased them, small caps have outperformed in all but two. Rate cuts tend to signal the bottom of a weak economic cycle, and small caps usually do well as the economy reaccelerates.
What's more, small stocks stand to get a stronger-than-usual boost this year from the so-called January effect. This arises because institutional investors tend to sell their more volatile holdings--which often means small caps--and buy blue chips in the fourth quarter to minimize the chance of nasty surprises in their year-end returns, which they report to shareholders. And if they have losers in their portfolios, as many funds do this year, they want to sell them by year-end to offset taxable gains. Once the new year starts they buy aggressively again, and the net effect is often a lift for small stocks. The effect used to occur in January, but since mutual funds increasingly report on an October-fiscal-year basis, the boost can be expected sooner, in November or December or even right now. "We're kind of already in it," says Jim Margard, manager of the Rainier Small/Mid Cap Equity fund.
Since small caps are a small part of the market, minor changes in the demand can make for an enormous impact on prices. Chuck Royce, manager of the Royce Total Return fund--who has followed small caps for 25 years--notes that since 1975, every time small caps declined more than 20%, they've snapped back at least 70% in the ensuing two years. His explanation: "In every case, when small caps underperform for so long, they go through a wretched moment where people give up and just puke them out."
Gary Haubold, who runs PBHG Small Cap Value fund, has been on a shopping spree in recent weeks and has already seen several of his new picks move 5% to 10%. As long as the economy remains recession-free, he's an optimist. "By March," he predicts boldly, "we're going to have a small-cap love fest."
Issue date: November 23, 1998
Vol. 138, No. 10 |
