You have to be small to get respect these days.
Stocks of small companies have outperformed stocks of large companies by an average of 20 percent over the past two years. Most recently, the Enron disaster has wiped out any pretensions that bigger is better.
Historically, small-capitalization stocks have outperformed large caps by 25 percent in the six months before the end of a recession, which is where some experts say we are now. The low interest rates we’re experiencing provide a further boost to these cash-hungry businesses.
This “small is beautiful” trend has become so pronounced that many managers are breaking their large companies into smaller pieces to make them more attractive to investors.
But here’s the reality check: Small-company stocks, though resilient, remain volatile and recent results look good mostly because big stocks tanked.
While small caps outperformed the overall market early this year in what’s commonly called the “January effect,” their results were actually negative. Last year, the average small cap gained less than 2 percent, though bargain-priced small-cap value stocks did rise 15 percent.
“Individual investors must realize that, even when we’re bullish on small stocks, it’s still a riskier asset that isn’t for everybody,” cautioned Satya Pradhuman, director of small-cap research for Merrill Lynch. “But the longer your time horizon, the better these assets hold up.”
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“Large caps are driven much more by what the U.S. and international economies do, while small caps have the advantage of being able to pursue niche opportunities,” said Jim Furey, small-cap strategist at J.P. Morgan Chase. “Coming out of a recession, small caps outperform.”
The small caps likely to perform best as we come out of recession are those in the consumer, health care, information technology and finance industries, predicted Jim Collins, editor of the OTC Insight newsletter (P.O. Box 5759, Walnut Creek, Calif. 94596). “The bottom line short term is that at least until we get into March and the reporting of first-quarter earnings, you should be a little cautious and not too aggressive,” counseled Collins. Still, it’s easier to find cheap small stocks than inexpensive large stocks right now, believes Ken Heebner, portfolio manager of CGM Focus Fund, up 73.61 percent the past 12 months. His bullish prediction is for an expanding economy this year and next. One-fourth of his portfolio is in home-building stocks.
“A big reason for the move to small caps is technology, since a small company can do what a large company does at half the cost,” said David Corbin, portfolio manager of Corbin Small-Cap Value Fund, up 25.25 percent the past 12 months. Merrill Lynch small-cap recommendations include Advance PCS (ADVP) in pharmacy benefit management; Argosy Gaming (AGY) in riverboat casinos; L-3 Communications Holdings (LLL) in adhesives; Protective Life Corp. (PL) in financial services; and Sonic Automotive (SAH), an automotive replacement part retailer.
At OTC Insight, favorites are Action Performance Cos. (ACTN), maker of motor sport die-cast replicas and souvenirs, and Umpqua Holdings (UMPQ), an Oregon bank holding company that also has a brokerage business.
Top CGM Focus holdings are homebuilders Beazer Homes USA (BZH), NVR Inc. (NVR) and The Ryland Group (RYL). It’s been successful with Frontier Airlines (FRNT) as domestic travel has picked up. Top small caps in Corbin Small-Cap Value include Forgent Networks (FORG) in computer-based videoconferencing; Buca di Beppo (BUCA) in Italian restaurants; and The Titan Corp. (TTN) in technology and electronic defense.
Because small caps are unpredictable, it makes sense to invest in a group of them or a mutual fund specializing in them.
The best-performing small-cap funds over the past 12 months, according to Morningstar Inc., have been:
CGM Focus (CGMFX); $401 million in assets; no load; $2,500 minimum; 800-345-4048; three-year annualized return of 37.45 percent; up 73.61 percent.
Schroder Ultra Investors (SMCFX); $191 million; no load; $10,000; 800-464-3108; three-year annualized return of 100 percent; up 66.22 percent.
Wasatch Micro Cap (WMICX); $485 million; no load; $2,000 minimum; 800-551-1700; three-year annualized return of 37.25 percent; up 33.17 percent.
Franklin MicroCap Value “A” (FRMCX); $302 million; 5.75 percent load; $1,000 minimum; 800-342-5236; three-year annualized return of 16.34 percent; up 30.55 percent.
Corbin Small-Cap Value (CORBX) ; $2 million; no load; $2,000 minimum; 800-924-6848; three-year annualized return of 13.92 percent; up 25.25 percent.