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Small caps bounce back
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June 17, 1999: 1:51 p.m. ETT
Time to think little after five years of big gains by the biggest stocks?
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NEW YORK (CNNfn) - It's been a five-year fling, this love affair for large-capitalization stocks. As investors' hearts pumped with every beat of MSFT, GE and INTC, small cap stocks have been lucky to get a second glance. But some investment pros say they're falling in love with small caps again.
It's a simpler world, looking at the biggest issues, and some investors might want to keep it that way. They shouldn't, according to Hugh Johnson, chief investment officer of First Albany Corp.
"You could look the other way for a while, but you no longer can," he said. "Investors should jump on board to something that could be pretty meaningful."
Why the shift in sentiment?
From mid-1994 to April, large cap companies outdid their smaller brethren by 120 percent.
"That's mind boggling," Johnson said, and precisely why small caps are a great opportunity right now.
"With every passing day, there gets to be more ground to make up," he said, adding that small- and mid-cap stocks are just good value.
Over time, the theory is that small and large cap stocks will produce similar returns. There's debate as to how true that is -- over how much time is an excellent question, one wag pointed out. But there's no doubt small cap stocks are relatively cheap right now.
That's because the bull market has left little companies behind.
"It's pretty heinous," said Jeffrey Berman, senior managing director of investment banking at Gruntal & Co. "Small- and mid-cap stocks, and even micro- and nano-cap stocks, have not participated."
Exactly what constitutes a large-cap or a small-cap stock is open to debate. But a good rule of thumb is that stocks with capitalization ( the number of shares times the stock price) of $5 billion and lower are small-cap. Mid-caps end around $10 billion.
Smaller stocks have some knocks against them, such as that they're tougher to buy or sell. But they're now too cheap to ignore, some say.
"You have tremendous values out there," Berman said. "Now that they've become so undervalued, the risk of liquidity is outweighed for the small as well as the institutional investor."
In fact smaller-cap stocks are better suited for individuals, because institutions can't typically move in and out of them very easily because they need to buy large blocks of shares.
Which doesn't mean it's time to liquidate all positions in large caps. "There are reasons why large cap companies have done better," Johnson said. "What's very intriguing is, that's changing."
Large caps did well for a reason
Large cap companies are well known and are widely viewed as more stable, which attracts newer investors. And many of the biggest mutual funds are so large they limit themselves to buying only stocks with caps over $5 billion because they can't buy a big enough position in companies less than that.
Demand makes the large-cap stocks perform better and it becomes a self-fulfilling prophecy, Johnson said. Plus earnings growth was slowing, which favored big caps.
But Johnson can pinpoint the week he thinks the momentum shift toward small caps started: April 9. That week the Russell 2000 index, a measure of small-cap performance, started to outperform the Russell 1000, mostly big-cap stocks.
Why? Higher inflation and higher interest rates benefit small caps, he said. More companies can raise prices, and they start to show better earnings growth. In that kind of economy, "you don't have to buy large companies like Cisco, IBM, MCI-Worldcom and Wal-Mart to obtain good earnings growth."
The other side of the coin is that the big caps can't produce the same kind of earnings growth they have in the past. That makes institutional investors start looking for the largest mid-cap stocks for better returns.
Berman expects small and mid cap stocks to benefit from a lot of merger and acquisition activity, too. Large companies will use their stock to buy their cheaper, smaller cousins, he said. "There are a lot of fallen angels and orphans out there."
But Johnson's main interest in smaller-cap stocks comes from their cheapness. When earnings grow broadly, "investors tend to migrate from stocks with high price-earnings ratios to stocks with reasonable to low price-earnings ratios."
That's where the smaller stocks win out. The median PE ratio for a small-cap company, between $1 billion and $5 billion, is 13.9, compared with a median PE of 25.4 for the biggest-cap companies.
Shift or broadening? There's a debate
Others describe the shift as a broadening of the market. When the global economy looked shaky 18 months ago, for instance, "you had investors clinging close to the earnings tree," said Bryan Piskorowski, a market analyst with Prudential Securities.
The "Nifty 50" large caps got the biggest benefit. Now it's clear global economies "are at least not headed off a cliff," he thinks some mid-caps, particularly energy and semiconductor stocks, are interesting. "It's not time to be preaching the Russell is back and everybody should ignore the 50," he said. "It's time to broaden your scope a little bit."
Christine Callies, chief investment strategist at CS First Boston, isn't convinced small-cap stocks are back. Oddly enough, she said their rebound will have nothing to do with small cap stocks themselves.
"It really isn't a beauty contest between big-cap and small-cap stocks that the small caps eventually win," Callies said. "It's started by a change in the economic environment that favors profit growth for both." When that happens, there's no scarcity value in stable, large stocks, so smaller ones get more attractive, she explained.
How do individuals benefit?
Still, she has noted an improvement in small cap performance. Other market analysts say the shift is more profound and well worth paying attention to.
But how best to take advantage of the rebound in small caps? Investing directly in small caps takes a good stock picker, perhaps better than investing in big caps. That's because it requires a lot of homework to sift through a bigger universe of more untested companies.
That can be done, but it can be frustrating. "The world doesn't wait for you to go through your research," Johnson said. "You're sitting there doing your research and while you twiddle your thumbs, Rome is burning."
Callies agrees, though she says investors shouldn't rule out the possibility of investing in small caps. "It's a matter of [an investor's] expertise and time constraints."
There is a wide variety of small-cap and mid-cap mutual funds for investors who don't have the confidence or time to look at specific small cap stocks.
Actually, mid-cap funds have performed the best this year, according to mutual-fund tracker Morningstar Inc. The average mid-cap fund is up 8.4 percent so far this year, compared with 7.7 percent for large-cap funds and 3.7 percent for small-cap funds.
The five best-performing mid-cap funds this year, all up more than 39 percent since January according to Morningstar, are the technology-oriented Nevis Fund; the Van Wagoner Emerging Growth Fund, which is very tech-oriented; the Van Wagoner Mid-Cap Fund, built around 10 mid-cap growth stocks; the Navellier Mid Cap Growth Fund, focused on undervalued growth companies; and the Loomis Sayles Aggressive Growth Fund, another mid-cap tech-oriented fund.
The best-performing small caps so far this year are the Van Wagoner Post-Venture Fund, specializing in companies with recent venture capital; the Van Wagoner Micro-Cap Fund; the Schroder Micro Cap Fund; the BlackRock Micro-Cap Equity Fund; and the RS Emerging Growth Fund, which focuses on technology. All are up more than 34 percent in 1999.
That shows a strong bias toward very small companies. The three micro-cap funds specialize in companies under $250 million in market cap.
Johnson pointed out that perhaps the best way to take advantage of a general rebound in mid-cap stocks is to buy the S&P mid-cap depositary receipts on the American Stock Exchange. That mirrors the performance of the Standard & Poor's 400 mid-cap index. "That's a very efficient way of getting mid-cap or small stocks," he said. 
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