The pluses and minuses of small-company stocks - investment management

Nation's Business, Dec, 1994 by Randy Myers

Is this a good time to invest in small-company stocks?

Conventional wisdom holds that small-capitalization stocks--defined here as companies with a total market value of less than $750 million--tend to outperform their larger cousins over the long term. Sometimes, the divergence can be dramatic: From 1991 through 1993, the Russell 2000 index of small-capitalization stocks posted a cumulative total return of 105.6 percent, compared with a gain of 54.6 percent for the Standard & Poor's 500, a widely recognized big-stock barometer.

But small-company stocks can be volatile. Because small firms have relatively few shares outstanding, it doesn't take a big buy or sell order to push their share prices up or down. And investors easily become nervous about small-company stocks when the economic going gets rough, recognizing that small firms don't have the resources bigger companies have to weather storms.

Little wonder, then, that small-company stocks are among the first to sink when business conditions deteriorate or the stock market turns sour.

In 1987, for example, when the market suffered its infamous October crash, the Russell 2000 lost 8.8 percent, while the S&P 500 earned a return of 5.2 percent. Even over moderately long periods of time, small stocks can lag. A hypothetical investment of $10,000 in the S&P 500 on Jan. 1, 1984, would have been worth $40,309 by Sept. 30, 1994, with all dividends reinvested, while the same investment in the Russell 2000 would have grown to only $28,352.

Small caps stumbled again in 1994, as inflationary fears and a consequent series of interest-rate rises by the Federal Reserve Board sent investors scurrying for the safety of blue chips. On Sept. 30, the Russell 2000 showed a total return of 0.05 percent for the year, while the S&P 500 boasted a return of 1.3 percent, and the Dow Jones Industrial Average, a purely blue-chip index, showed a total return of 4.4 percent.

"It's unfortunate, but sometimes that's when opportunities can be found," says Robert Kippes, a mutual-fund manager who guides the high-performance AIM Aggressive Growth fund and invests it almost exclusively in small-cap stocks. Not that Kippes has had much reason to worry. Despite the broad market's problems, his fund rose 11.2 percent through the first nine months of 1994, primarily on the strength of investments in small technology and healthcare companies.

Kippes remains optimistic about the outlook for small caps. So does Ronald Elijah, who runs the $48 million Robertson Stephens Value Plus fund. He says the health-care and technology sectors still have room to run. The former should continue to benefit from the aging of the U.S. population, and the latter from the pervasive spread of technolgoy into every aspect of American life--from gasoline pumps with credit-card readers to computers that also serve as television sets, answering machines, and alarm clocks.

On the macroeconomic front, Elijah theorizes that a slowing but still growing U.S. economy, combined with low inflation, will allow corporate earnings to come in strong in 1995, sending stock prices higher and allowing small caps to outperform the market once again.

All of that may not mean much for investors who don't invest in small-cap stocks as a matter of principle. Robert Bowen, a senior financial consultant with Merrill Lynch in York, Pa., says many small-business owners take that approach. Having risked everything to build their own businesses, he says, they're not inclined to invest their profits in other small, risky ventures.

But that kind of thinking deprives owners of a chance to capitalize on the unique insights they can bring to their investments, according to Steven Wilk, president of TransNet Corp., based in Branchburg, N.J., a seller of computers and computer services. "Because I am intimately involved with a small business, I feel I have an advantage when I look at the balance sheet and profit-and-loss statement of another small company," Wilk says. "I have an ability to place myself in another CEO's seat."

Mark Cuban, who in 1991 sold his Dallas-based computer systems integration company, Micro Solutions Inc., agrees with Wilk. "Running a business and investing in a business go hand-in-hand," says Cuban, who now splits his time investing and consulting. "When you're an industry insider, you understand the momentum of an industry, the nuances of changes in suppliers, policies, approaches, strategies. You can anticipate the impact of these things. On the outside, you can only react."

What should an investor do to take advantage of the historically strong but volatile performance of small-cap stocks?

First, play to your strengths, scouring the industry you know best. Cuban, for example, invests only in stocks of companies involved in personal-computer technology. But diversify your holdings, too, by investing in more than a few stocks. If your portfolio is too small to do that on your own, consider a mutual fund that specializes in small-cap issues.