This is an anomaly, as anyone familiar with long-term statistics will tell you. Since 1926, small-company stocks have beaten the market by about 20 percent, and that’s the way it’s supposed to be. Small caps–“little” companies with market values of around $1 billion or less–are feisty, risk-taking and worth a premium, because when they catch fire, they really blaze. From 1991 to 1993 they returned 27.2 percent a year, while larger stocks returned less than 17 percent. In the early ’80s they were the place to be.
Lagging performance: That was then and this is now: the GEs and Disneys of the Dow have been beating the stuffing out of the small caps. Small-company stocks are selling at their biggest markdown in 20 years, says Claudia Mott of Prudential Securities. “They look incredibly cheap. You’ve never seen this long a run of good earnings growth and lagging performance.”
So why aren’t investors cashing in their blue chips for a ride on the Russell 2000, the small-cap index? Money manager Robert Markman, who believes the domination of large caps is the new world order, ticks off five good reasons: (1) the indexing boom is sending billions of dollars into the S&P 500, driving up big-cap prices; (2) almost all the money invested by foreign shareholders goes to big household names; (3) big firms aren’t dinosaurs anymore; many are technology-laden and quick on their feet; (4) it’s easier to sell highly liquid blue chips at good prices, and (5) the small-cap market was flooded with initial public offerings over the last three years, creating an oversupply.
Clearance sale: Small-stock fans counter that the S&P 500 extracts too great a premium for its popularity. When measured by their price-earnings ratios, small stocks are only 82 percent as costly as big-company shares. You’d have to spend $1.22 on the S&P 500 to get the expected earnings $1 will buy you in small caps.
“Sooner or later, a lot of investors are going to be upset that their only exposure to the U.S. market is in large caps,” says Mott. Steve Heywood of the Marshall Small Cap Growth Fund argues that small firms will either grow on their own or get bought out–at profitable prices. Even small-stock skeptics like money manager David Dremen concede investors should keep 5 percent to 10 percent of their stock portfolios in small caps for when they do catch fire. Why not do that now, during the best summer clearance sale in years?
Too big? If just convincing yourself to buy a small-stock fund is work, wait until you try actually finding the right fund. You can’t rely on index funds; in the complex small-cap market they won’t do as well as a good stock-picking fund manager. You can’t rely on the small-stock funds of yore, either. Two of the most widely held, Twentieth Century Ultra and Baron Asset, got too big for their markets years ago and have loaded up on bigger companies. Small-cap managers suffer a well-grounded fear of success: if their funds grow too fast, they’ll end up with more money than they can easily tuck into the small companies they want. Fund managers with too much cash can distort share prices with big-money trades, get stuck buying companies they don’t want and sacrifice profits to trading costs. To avoid these troubles, more than 30 of the best and biggest small-cap funds have closed to new investors, reports Morningstar Mutual Funds analyst Russel Kinnel. In the small-cap market, he says, you need to get into a fund before it develops a successful record and a following.
Which is not to say there are no signs of small-cap success. Look for a fund with less than $1.5 billion in assets. Seek funds that mix growth and value strategies and are run by fund managers with good records, even if those records were built elsewhere. Buy from firms that are good at closing their funds before they get too big, says Kinnel, who now favors Third Avenue Small-Cap Value, T. Rowe Price Small Cap Stock and MAS Small Cap Growth funds.
