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Small caps making comeback?
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April 26, 1999: 3:55 p.m. ET
Strong earnings, increased mergers propel small shares higher, but can surge last?
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NEW YORK (CNNfn) - After years of getting upstaged by larger shares, small cap stocks seem to be making their way back into the spotlight.
In April so far, the Russell 2000 has climbed more than 9 percent and the index is up more than 2 percent for the year. The S&P, in turn, has climbed about 5 percent for the month to date.
Analysts say strong earnings, along with some weakness in the once supreme technology sector, have been the driving force behind the comeback.
"With those two factors coming together, small caps look very attractive right now," said Steven Yeary, senior portfolio manager of Value Line Asset Management.
An increase in merger and acquisition activity also has spurred investor interest in small cap funds, said Grant Babyak, a portfolio manager at Fiduciary Trust Co.
"In the past week or so, the number of corporate buyers lurking around for acquisitions has really jumped. … That's really caused people to focus on where the next acquisition may be," Babyak said.
Shares of RCN Corp. (RCNC) and TCA Cable TV Inc. (TCAT), for example, shot up after a flurry of telecom deals, including a proposed $58 billion marriage between AT&T and MediaOne last week, caught investors by surprise.
Finally, small caps have benefited from the general trend away from more well-known, high-priced blue chips, said Annette Geddes, portfolio manager at M.D. Sass.
"The Nifty Fifty were way ahead of themselves. It's simply the law of physics," Geddes said. This "could be a changing of the guard here without the overall market really having to be negatively impacted."
Can it last?
Analysts seem to agree that the broad-based nature of this most recent small cap rally bodes well for the long term, as valuations finally catch up with fundamentals.
Many small cap portfolio managers believe small stocks have long been underpriced, with one analyst putting valuations at 40-year lows.
"I keep going back to earnings and realistic valuations," said Yeary. "There is high growth in small caps. You've got very attractive valuations. You're not paying 100 times earnings," as is often the case with popular Internet-related stocks.
As stronger-than-expected results pour in among small companies, investors finally may be waking up to the strong fundamentals of smaller firms, another analyst said.
"Institutional investors are rebalancing away from the large cap side of the market. The are recognizing that large caps have had a long run and this may be the end of the cycle for them," Babyak said.
Good climate for small caps
In addition to the strong earnings performance of smaller companies, the general market climate has had a positive impact on small cap stocks, analysts said.
For one, with the global financial crisis no longer in the headlines, investors are more likely to embrace small caps, which tend to be less liquid.
"Investors have much more confidence in the overall market right now," Yeary said. "Asia is not getting worse. Brazil and South America are not getting worse. ... This is an environment in which small caps can do better."
Generally, when investors become more willing to take on risk, small caps are rewarded.
In addition, the absence of any major initial public offerings could place smaller stocks in higher demand, Babyak said.
"The deal flow we are seeing out there from companies trying to go public is not overly excessive right now. ... That's positive from a supply point of view," Babyak said.
Bargains for everyone
Despite the recent rally, many Wall Street watchers believe small caps have a bright future and that plenty of investment bargains remain.
"I see no reason why (the upturn) shouldn't last," Geddes said. "We have waited so long for this to happen."
Though Geddes admitted trading could be choppy through the second quarter, as long as interest rates and inflation remain steady, she believes small caps have "a long way to go."
With consumer confidence and consumer spending still strong, analysts continue to favor retail stocks. Those cited include Tiffany & Co. (TIF), Zales (ZLC), Wild Oats (OATS), Talbots (TLB) and Ames Department Stores (AMES).
Semiconductor firms also came out on top, with portfolio manager Yeary recommending PMC-Sierra Inc. (PMCS), Micrel Inc. (MCRL) and Dycom Industries (DY).
In addition, Geddes likes oil services companies, such as Superior Energy Services (SESI) and Eagle Geophysical (EGEO), citing low prices, strong earnings potential and improved cash flow.
And, the portfolio manager said, smaller Internet stocks also have some growth potential, though she admitted those issues come with risks.
"We own (Internet stocks) and we've been very successful with them. But we've traded positions around constantly," she said, recommending TMP Worldwide (TMPW), Exodus (EXDS) and VeticalNet (VERT).
-- by staff writer Nicole Jacoby
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