The Big Moment For Small-Caps? When Small-Caps Rebound, It's Likely to Be Quick
By James K. Glassman
(excerpt)
Sunday, October 11, 1998
Of the 706 mutual funds that specialize in small-
company stocks, only three have made money over the
12 months ended Oct. 1. Since I remain a fan of such
stocks, I decided to talk to the managers of the top
two of these anomalous funds to find out how they did it.
First, let's set the stage. So far this year, despite
the devastation of the past three months, the Dow Jones
industrial average is down only 0.1 percent and the broader
Standard & Poor's 500-stock index is up 1.4 percent.
But the Russell 2000 index, which tracks small-cap
stocks (that is, stocks with a small capitalization,
or market value), has fallen an incredible 27.1 percent.
If the index drops only another four percentage points
over the next 2 1/2 months, this will be the worst year
for small-caps since the Great Depression.
The Nasdaq composite index is often cited by journalists
as a proxy for small-caps, but it's not a good one. While
most small stocks trade over the counter on the Nasdaq
Stock Market, the index itself is dominated by just five
very large-cap stocks -- Microsoft, Intel, MCI WorldCom,
Cisco and Dell Computer -- which account for more than
60 percent of the movement in the index. All five of these
stocks are well ahead for the year (Dell has more than
doubled). Even so, the Nasdaq is down 5 percent.
The carnage in the Russell, a better measure, has been
staggering. The index is down 35 percent from its April 21
high and 20 percent in the most recent quarter alone --
the third-worst quarter in its history. Also historic
is the divergence between small-caps and large-caps. For
example, on Oct. 1, the price-to-earnings (P/E) ratio of
the average small-cap stock was 13 percent lower than the
P/E of the average large-cap. Historically, small-caps,
because they're fast growers, have sold at a P/E 21 percent
higher than large-caps.
A survey on Aug. 31 found that the average Nasdaq stock
had fallen 49 percent from its high for the year. If
anything, that loss is worse today.
"They have just taken these companies out and shot them,"
says Philip Trieck, the 34-year-old manager of the top-
performing small-cap fund, Transamerica Premier Small
Company (1-800-892-7587), which for the year ended Oct. 1
had returned 9.3 percent, compared with a loss of 24.4
percent for the average small-cap fund. "It's a blood
bath out there."
Equally colorful is Mark Seferovich, manager of the number
two small-cap fund, Waddell & Reed Growth (1-800-366-5465),
up 7.1 percent. "Stocks are falling faster than you can buy
them," he told me. Still, when small-caps come back, they
should come back with a vengeance. As Paul Greenwood, a
senior research analyst at Frank Russell Co., puts it:
"Small stocks have never sold at this large a discount . . .
to large stocks. An extreme valuation is like a rubber band.
The further it stretches out, the greater the potential for
an eventual bounce-back."
Trieck points out that the best year for small-caps in the
past two decades was 1991, when they returned a staggering
44.6 percent. What was significant about 1991? Well, it came
right after 1990, when small-caps were massacred, falling
21.6 percent -- their worst performance in a quarter-century
(but one that may be eclipsed this year).
So small-caps do tend to bounce back. The key question,
says Greenwood is "When will this occur?"
No one knows. For at least a year, the market's volatility
has inspired fund managers and other investors to seek shelter
in the liquidity and predictability of large-cap stocks.
Liquidity means a company has a considerable number of
widely held shares, and investors thus enjoy ease of getting
in and out. Predictability means a solid customer base,
good brands and regular earnings.
But favored large-cap stocks have been bid into the
stratosphere. Even after falling 28 percent in recent
months, Coca-Cola Co. still trades at a P/E of 40. The
stock could certainly rise from here, but by how much?
"At some point," said Seferovich, "a sacrifice of liquidity
and brand name will have to be made if you want a rate of
return." And to get that return, investors will turn to
small-caps, with their low valuations -- that is, low P/Es,
price-to-book ratios and price-to-cash-flow ratios.
"The little ones are set up," Seferovich said of the small-
caps, "but the timing will be dragged out" -- mainly because
the Asia crisis is spreading west and the desire for safety
will only intensify.
Grant Sarris, who is Seferovich's co-manager in Overland Park,
Kan. (Trieck is in San Francisco, also far from the madding
Wall Street crowd), points out that the big large-cap funds
have traditionally kept about 15 percent of their assets in
small-caps, but lately, since they have had such a hard time
beating the S&P with small-caps as a drag, large-cap managers
"have abandoned small-caps."
But, says Sarris, "if small-caps outperform a little, they'll
rush in." The rubber band could snap back smartly.
...It could be six months, a year or more before small-caps
turn around, but when they do, it will happen very quickly.
Between 1991 and 1993, for example, small-caps jumped
116 percent while large-caps rose only 55 percent.
Meanwhile, with more cash than they would like, plus a few
dozen good small companies, they're on the lookout for decent
buys. But mainly they're waiting until investors get wise to
small-caps once more.
© Copyright 1998 The Washington Post Company
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