Small stocks are still flying low

Kiplinger's Personal Finance Magazine, Oct, 1998 by Manuel Schiffres

Correction? What correction? No sooner had Wall Street uttered the word than it seemed to evaporate into the ether. Besides, the official definition of "correction"--a 10% drop in stock prices--applied only to stocks measured by the Dow Jones industrial average or Standard and Poor's 500-stock index. While the Dow and the S&P have been flirting with corrections, there has been outright carnage among the vast majority of stocks in general, and small stocks in particular. They've been waltzing with bears.

Statistics from Salomon Smith Barney drive home the point. By mid August, stocks with market values of $2 billion or less had dropped an average of 14% since January. Stocks with market values of $20 billion or more had climbed an average of 10%.

Or look at it another way: On the same late-summer day those numbers were gathered, 59% of Nasdaq stocks and 40% of New York Stock Exchange stocks were off 30% or more from their 52-week highs. Stocks with market values of $250 million or less had declined, on average, 47% from their 52-week highs. The Russell 2000, a measure of small-stock performance, had sunk 19% from its April 22 high. Small-company stocks were engulfed in their own private bear market.

THE CAUSES. This is nothing new. Small stocks have trailed large stocks every year since 1994. Analysts generally tie the 1998 rout to the economic crisis in Asia. That seems odd on the surface because smaller companies are less likely than larger ones to have overseas operations. However, when investors become skittish, they tend to gravitate toward the largest, best-known and presumably safest names. As editor Susan Belden of No-Load Fund Analyst newsletter puts it: "When the market gets into trouble, small caps tend to get into bigger trouble."

Over the longer period, analyst Claudia Mott of Prudential Securities says, small-company stocks are suffering from "flow of funds" disease. Money is pouring into only a select number of larger names, leaving small companies behind. Mott cites three sources for this "overpowering demand" for large stocks. The first is foreign investors, who dramatically accelerated their purchases of U.S. stocks late last year and early this year and tend to buy only the 50 largest stocks. The second is individual investors in 401(k) and other retirement plans, who invest disproportionately in large-company stock funds. The third is "closet indexers"--money managers who seek to keep up with the S&P 500 by buying its largest components, such as Microsoft, Pfizer and Cisco Systems.

BETTING ON THE CURE. As a result of all this neglect, rarely have small-company stocks been more attractively priced. The Russell 2000 index recently sold at 16 times estimated earnings for 1999, while the S&P sold at 20 times, reports First Call. Yet, according to a consensus of analysts, Russell 2000 earnings are expected to jump 32% in 1999, while S&P profits climb just 16%.

So smaller companies seem to promise more growth at a substantially lower price. But Arun Kumar, a strategist at Lehman Brothers, cautions that small stocks "can stay cheap for a long time." In fact, he thinks big-company stocks are in the driver's seat indefinitely. They can boost profits by grabbing market share overseas and continuing to trim costs.

Ultimately, it may take a full-bore bear market before the small names begin to justify their reputation for delivering big returns. Mort recommends owning at least one fund that buys undervalued small stocks and one that buys rapidly growing small companies. Among small-company growth funds, newsletter editor Belden favors Berger Small Company Growth (800-551-5849) and Robertson Stephens Microcap Growth (800-766-3863). On the bargain-hunting side, she likes CRM Small Cap Value (800-844-8258).

If you're already a frustrated investor in a small-company fund, think twice before dumping it. It's pointless to compare a small-cap fund with the S&P 500. Instead, check its performance against the Russell 2000. Internet users can get updates at www.russell.com.

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