SMALL STOCKS: STILL A SMART BET
(FORTUNE Magazine) – It was a great beginning. After nearly eight years as market wallflowers, small stocks went on a tear in 1991, returning 44% to investors. But the rally soon stalled: The Russell 2000 index, a good proxy for midget shares, is down 1% since the start of 1992, slightly worse than the overall market. Is it already time to cash out and move your gains to greener pastures? In a word, no. Analysts say the stocks of small companies, while facing rough going at the moment, still offer the best prospects for outperforming the broad market over the next few years. They offer superior growth rates, sell at attractive valuations, and are in the most promising phase of the economic cycle. Notes Ralph Wanger, manager of the Acorn Fund, a high- performing small-stock fund: ''In general, small stocks tend to outperform large shares in economic recoveries.'' That doesn't mean there won't be more lumps. Small stocks tend to get whacked hardest in broad market declines -- a strong possibility given the market's pricey valuation. Also, the small-stock sector has had an influx of initial public offerings. IPOs tend to underperform the market in their first few years (for an exception, see next story). The big crop of fresh faces may dampen overall performance for a spell. But investors who hang in there should be well rewarded. Small- capitalization shares enjoy rapid growth rates, and the companies are often better able than their big brothers to cope with a weak economy. Says Loren Hansen, a money manager at the Northern Trust company: ''In a sluggish economy, smaller companies can adapt more quickly to improve their profitability.'' Of course, they also carry some higher risks owing to their small capitalizations. Believe it or not, more good news for small stocks could come from politics. They sport a winning record under Democratic Administrations (see chart), perhaps reflecting the propensity of Democrats to use fiscal stimulus to create jobs, which helps small companies most. According to Liberty Asset Management in Westport, Connecticut, small stocks averaged annual returns of 23.1% in the Kennedy/Johnson years and 32% under Carter, compared with 10.1% and 11.8%, respectively, for large stocks. Given the recent presidential polls, small stocks could be dancing again by January. So which small shares are best to buy? Chuck Royce, who manages the Pennsylvania Mutual Fund, is focusing on stocks that have dropped to bargain levels. Among the most promising are the depressed stocks of software makers, which were driven down by disappointing earnings earlier this year. Says Royce: ''These are very attractive companies with super balance sheets, and sell for only ten times earnings or so. They're just in the bad part of their cycle.'' Among Royce's buys are Lotus Development and American Software. Analysts expect Lotus to increase earnings 15% annually over the next five years and American Software profits to grow at a 20% annual rate. Royce is also buying companies that have fallen on hard times but whose dividends are shining bright. Among his favorites are Community Psychiatric Centers, which reached $40 a share last year but collapsed to $9, partly as a result of weaker earnings. More important, the stock was dragged down by investor uneasiness over lawsuits filed against a rival company for billing improprieties. Community Psychiatric was not implicated, and Royce believes that once the dust settles, investors will flock back to the stock. Meanwhile, the shares yield 4%. He also likes Manitowoc, which makes industrial cranes. The company made its way through an industrywide depression in the early Eighties, emerging in good shape, says Royce, and it is poised to benefit from greater spending on infrastructure. The stock yields 4.4%. The leisure industry has good growth prospects, thanks in part to a rising number of retired folks, according to Ralph Wanger of the Acorn Fund. His favorite play is Carnival Cruise Lines. ''Cruising is a great business because it offers a cheap, one-stop vacation,'' says Wanger. ''It's a no-brainer. You make one call to a travel agent and show up with a bathing suit.'' He thinks the weak dollar will also tempt foreign tourists to try Carnival's ships. The stock sells for $26, or 11 times expected 1993 earnings of $2.30 per share. Beyond 1993, Carnival's earnings are expected to cruise ahead at a 15% annual rate. Loren Hansen of Northern Trust likes Federal Signal, which makes emergency fire-safety vehicles, commercial signs, and warning devices, such as sirens. ''It's the dominant player in those industries and is now focusing on exporting that expertise to Europe,'' says Hanson.Hansen.ok? The stock sells for 16 times expected 1993 earnings of $1.17 per share. CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: SIX THAT SHOULD SIZZLE These six small-cap stocks are poised to log big gains. Community Psychiatric and cranemaker Manitowoc offer generous yields too. CHART: NOT AVAILABLE CREDIT: SOURCE: LIBERTY ASSET MANAGEMENT CAPTION: SMALL-STOCK RETURNS WHEN THE PRESIDENT IS A. . . REPUBLICAN DEMOCRAT |
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