** Small Cap Must Read ** March 5th Boston Globe:
Fund crushed by large stocks
By Steven Syre and Charles Stein, Globe Staff, 03/05/99
ohn Laporte and the executives at Levi Strauss have a lot in common:
They are both selling a product that is hopelessly out of fashion. In
Laporte's case, it is small stocks.
Laporte runs T. Rowe Price's New Horizon fund, sometimes referred to as
the grandfather of small-cap funds. For the past 38 years, 12 under
Laporte's direction, the fund has been investing in small-growth companies.
Laporte's long-term track record is terrific. In 1995 his fund was up 55
percent. But for the past few years, he's been in the wrong place at the
wrong time.
Big stocks aren't just outperforming small stocks. They are crushing them.
Last year the Standard & Poor's 500 index, a proxy for big stocks, rose 28
percent. The Russell 2000 index, a proxy for small stocks, rose just over 1
percent.
This year is shaping up no better. Big stocks are up slightly; small stocks are
off more than 6 percent. Investors have reacted by yanking money out of
small-cap funds, including New Horizons.
''Investors got their year-end statements, saw that we did 6.2 percent
compared to 28 percent for the S&P and said, 'Why do I want to be in
New Horizons?''' says Laporte.
Historically, the stocks in Laporte's portfolio have had a higher
price/earnings ratio than do large-cap stocks. It makes sense. Small
companies have the potential to grow much faster than their large
counterparts.
But last year, for the only the third time in the last 38, New Horizons's
stocks had a lower price/earnings ratio than the stocks in the S&P 500. At
the moment the ratio is more out of whack than it has been in the entire
history of the fund.
Why are small stocks so out of favor?
''I don't have a good answer to that,'' says Laporte. Part of the answer, of
course, is the rise of indexing. Investors have poured enormous sums of
money into S&P 500 index funds, which guarantees more cash will flow into
the big stocks that have already done well. Another part of the answer is the
excellent earnings performance of the big companies, especially technology
giants such as Microsoft, Dell, and Cisco.
Some have suggested that the advantage the giants enjoy may be a
permanent one. The argument goes something like this: In today's open
global economy, big companies have greater power than ever to cut costs,
raise prices, and dominate markets. And when the big firms see a small
company that poses a competitive challenge they don't sweat it. They just
buy up the little company. Microsoft and Cisco have bulked up on a steady
diet of small rivals.
Laporte doesn't accept the notion that the world has changed so profoundly.
''Small companies continue to have the advantage of being more nimble,'' he
says. ''Well-managed small companies should be able to grow earnings
faster than large companies do.''
The problem for Laporte is that even when small companies perform well,
their stocks get hammered. He cites two examples from his portfolio: Apollo
Group Inc. and Henry Schein Inc.
Apollo is in education; Henry Schein is in health care. Both companies have
had solid sales and earnings growth. Yet Apollo's stock is down 25 percent
from its high and Henry Schein is off 35 percent. To Laporte, it looks as if
investors are throwing out the baby with the bath water.
Small-cap stocks have been down before. In fact, over time their
performance is almost biblical: five to seven years of good times followed by
five to seven years of lean times. Small stocks have been in a relative slump
since 1994. So should investors expect the tide to turn soon? Laporte's
answer: Don't hold your breath.
''I think we will need a pretty good washout in the current market leaders
before we get a reversal,'' he says. In other words, the big stocks will have
to crumble first, Laporte argues.
Even then, small stocks won't be out of the woods. Laporte predicts it will
take a broad correction and then a subsequent rebound for the small stocks
to begin a new cycle of strong performance. And with the economy in such
good shape, that washout may not be on the horizon, says Laporte.
The fund is not about to change its stripes. Laporte will continue to look for
small companies that have the ability to increase earnings at 25 percent a
year. Like the bell-bottoms in your closet, such companies are bound to
come back into fashion sometime.
''The disparity in valuations inevitably has to close,'' says Laporte. Right
now, it's just hard to say when ''inevitably'' will be |
