Commentary: Why Small-Caps Will
Keep Getting Trampled
BUSINESSWEEK ONLINE : APRIL 12, 1999 ISSUE
NEWS: ANALYSIS & COMMENTARY
If finally seeing the Dow close above 10,000 on Mar.
29 didn't mean much to you, you're in good company.
Peer closely at the market, and you'll notice that vast
sectors of Corporate America and the investors
backing them have been sitting on the outside, looking
in on this party. And the chances are, they're not being
invited anytime soon.
The Dow Jones industrial average has, incredibly,
doubled since November, 1995. But if you were
among those who thought small-caps offered more
growth potential than, say, IBM (IBM), you were out
of luck. The Russell 2000 index, which tracks some of
the nation's smallest companies, has risen just 32%
during the Dow's climb. And it is down 9% since the
beginning of 1998.
Small companies are getting crushed, unless they have
''.com'' in their name, of course. And big
companies--that is, really big companies--are soaring.
The dichotomy is breathtaking. The 100 largest
companies in the Standard & Poor's 500-stock index
have contributed roughly 90% of that index' 6.8% gain
this year, according to Morgan Stanley Dean Witter.
ROCKY ROAD. The market's lack of breadth makes
it seem like a shaky foundation for another leg of a bull
market. True, many of Wall Street's top strategists,
including Abby Joseph Cohen, the sage of Goldman,
Sachs & Co., predict that the Standard & Poor's index
of 500 stocks will rise 8% by yearend. But for
investors hoping that Dow 10,000 will somehow lift the
flagging fortunes of a broader array of stocks, the news
is not promising. Even so, most market mavens believe
small stocks will continue to suffer. ''The only thing that
could change this right now is a major shock to the
system,'' says Scott Black, a small-cap specialist at
Delphi Management in Boston.
What's boosting the giants? Above all, it's their ability
to generate strong, sustained profit growth. Over the
past five years, earnings at the nation's 30 largest
companies have increased 19.5% on average, says
Jeremy J. Siegel, a finance professor at the Wharton
School. The comparable figure for Russell 2000
companies is less than 10%. And they've swung wildly.
This year, the earnings outlook is foggy. Analysts
expect small-cap profits to be up 26% and large-cap
profits to gain 17%. But large-caps should still come
out ahead in the stock market. The reason? Investors
trust profit forecasts for large companies more than
they do for small companies. That makes sense, given
the long track records of such companies. ''As long as
investors are making 20% returns investing in the S&P
500, they think: 'Why should I bother with anything
else?''' says John Ballen, chief investment officer at
Massachusetts Financial Services in Boston.
The big boys are also the biggest beneficiaries of low
inflation. In an economy where most companies have
little pricing power, many of the top U.S. companies,
such as Microsoft (MSFT), Intel (INTC), Pfizer
(PFE), and General Electric (GE), have a greater ability
to control costs than smaller companies--by
strong-arming suppliers, for example. Similarly, large
companies' high stock prices and strong profits give
them enormous flexibility to acquire smaller companies
and expand.
COMEUPPANCE. Small-caps have another
drawback: They lack liquidity. Mutual-fund investors
have pulled some $8 billion out of small-cap funds so
far this year--for small stocks, no small deal in terms of
selling pressure. Most issues are so thinly traded
anyway that big investors can't buy large blocks
without affecting the stock price. At the same time, the
popularity of Net stocks is sucking away capital from
otherwise attractive non-Net companies, both big and
small. Stock in DelMonte Foods Co. (DLM), for
example, is down 22% from its February initial public
offering.
History shows that small-caps will eventually get their
due. After all, for seven decades, from the 1920s
forward, small-cap stocks earned a 12.5% average
annual return, vs. 11.2% for large caps, according to
Ibbotson Associates in Chicago. Small stocks have
almost always outperformed large stocks following
recessions, and sometimes after major market
corrections. ''Clearly, history shows that the trend is
going to change at some point,'' says Ballen. But it
won't be because of Dow 10,000.
By Geoffrey Smith
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