Got Too Many Marbles In Small-Caps?
After a great run, stocks of small companies look pricey. It may be time to make a trade.
By Penelope Wang

(MONEY Magazine) – What an awesome streak. For six straight years, the stocks of small companies have outpaced large stocks big-time, chalking up an annualized 9.4% gain vs. a paltry 1.7% return for blue chips. Naturally, investors have noticed, and they poured $21 billion into small-cap funds in just the past year.

Can this rally keep going? Perhaps, but warning signs abound that small-caps are peaking. "We figure we're in the last inning or two of this ball game," says Liz Ann Sonders, chief investment strategist at Charles Schwab. That's not to say you should dump small-caps: They help to diversify your portfolio. But their shares tend to swing more wildly than larger stocks', and they're starting to look especially risky now. Here's why.

It's been too good for too long. Small stocks usually rack up the biggest returns during the early stages of an economic recovery. That's because smaller companies tend to suffer the most in a downturn and then rebound more quickly as the economy comes out of recession. The current recovery has reached its mid- to late stage, forecasters say, which is typically a time when large-cap stocks take the lead from small stocks. "We expect investors to get more defensive this year and seek out large-caps, which offer steadier growth prospects," says Steven DeSanctis, director of small-stock research at Prudential Equity. "That's why it may make sense for investors to shift some money from small to large stocks."

Prices are higher but earnings aren't. Because small stocks are risky, on average investors give them a lower valuation than large stocks. But the recent rally has pushed small stocks up to the point that their average price-to-earnings ratio stands at 26.9 vs. 19.9 for large stocks--a 26% premium. "For small-cap stocks to outperform at this stage, you need stronger earnings growth compared with large-caps," says Jack Laporte, manager of T. Rowe Price New Horizons. "But as the economy continues to slow, you're not likely to see those 20% earnings gains."

The bargains are gone. Fact is, the small-cap bull run has been almost entirely one-sided. Bargain-priced small stocks, which are favored by so-called value investors, have zoomed ahead. Meanwhile, stocks that typically have faster-growing earnings and higher share prices have lagged. From early 2000 through the end of 2004, small value stocks gained a cumulative 113%, while small growth stocks posted a 23% loss. "We've been in a stealth value bubble," says Erik Ogard, portfolio manager at Russell Investment Group. "Investors have been nervous about terrorism and the Internet meltdown, so they have favored lower-risk value stocks while avoiding growth."

By now, however, few bargain stocks have been left undiscovered. As a result, many small value fund managers, who've been swamped by cash inflows, have closed their doors to new investors. Among them: Robert Rodriguez of FPA Capital, Steve Romick of FPA Crescent, and two Wasatch funds. "It's slim pickings right now. We haven't purchased a new stock in eight months," says Rodriguez, who is holding a third of his portfolio in cash. "Quite frankly, this is a terrible time to be deploying capital."

Not every analyst is so bearish, and some believe that buying opportunities may still be found among long-beleaguered small growth companies. "Growth stocks are now much cheaper than value stocks by just about any measure," says DeSanctis. "Investors have found out the hard way that valuations matter, so we expect a move toward growth stocks this year." But before you double down on small growth stocks, realize that they'll likely underperform too if investors turn back to big stocks. And just as this rally has gone on a while, small-caps can lag badly for years too, as they did from 1994 to 1999. Given that the risk in small-caps seems high these days, what should you do? Here are four steps you can take.

FALL OUT OF LOVE WITH SMALL STOCKS. If you're one of the millions of investors who have been throwing money into small-caps just because they've been going up, stop the madness. You don't want a repeat of 2000, when investors chased the performance of tech stocks--with disastrous results. So rebalance now by taking profits in high-flying funds or stocks and moving the money into other parts of your portfolio that have been lagging, such as large-cap growth stocks. Granted, it's tough to invest in what seem to be underperformers, but the rebalancing process is essential to lowering the risk in your portfolio. Haven't rebalanced for years? You may be overinvested in small stocks, even if you haven't put any new money into them.

CONSIDER HOW MUCH YOU CAN REALLY BEAR TO LOSE. It's easy to believe you are an aggressive investor when you're making money. But remember, small stocks are, by nature, more volatile than blue chips. So think about how you'd feel if there were double-digit minus signs on your funds' total returns. If that prospect doesn't faze you, you may be comfortable with an asset mix that puts 25% of your portfolio in small-caps. But if you don't think you could ride out those losses, consider trimming back your small stocks to 10% of assets. (See the model asset mixes on page 100.)

VENTURE OVERSEAS. You may not have thought to look abroad for small-cap investments. If so, you are missing out on great opportunities, as well as an important source of diversification. (For more on this strategy, see Market Maven on page 112.)

DON'T BET ON ONE TYPE OF INVESTING STRATEGY. Diversification also counts when it comes to investing style. That means owning both value and growth investments, since they tend to do well at different times. You can identify your funds' investing styles by going to our website, Money.com, and typing in your funds' ticker symbols. Given the stellar returns in value funds, chances are your portfolio is tilted toward that style. So as part of your rebalancing, move some of those gains into a small growth fund. Two excellent candidates are Neuberger Berman Fasciano (NBFSX; 800-877-9700) and Vanguard Explorer (VEXPX; 800-851-4999). Both are in the MONEY 50, our list of recommended mutual funds. Or keep things simple by switching to a single blend-style fund, which holds both value and growth stocks, such as Royce Pennsylvania Mutual (PENNX; 800-221-4268), also a MONEY 50 entry.

...so you may want to reduce your small-cap exposure and rebalance your portfolio.