‘Secondary’ Stocks Strong, Riskier

Small-company stocks, the slowpokes of the 1982-87 bull market, have finally raced to the lead, outperforming blue chips so far this year in what some proclaim as the start of a new bull market in these “secondary” stocks.

Since Jan. 1, the NASDAQ composite index of over-the-counter stocks--the most often-cited measure of secondary issues--has soared 15.47%, outstripping the 7.66% gain for the blue-chip-laden Dow Jones industrial average. Small-company growth funds are top performers this year among mutual fund groups, jumping 15.61% versus 9.91% for all equity funds, according to Lipper Analytical Services. Some small-company stocks have more than doubled in just the last month alone.

But can these little stocks keep it up? Should you buy?

Much evidence suggests that small stocks will perform at least as well as blue chips for the next few months and possibly the next three or four years. If they do, they will only be reaffirming a historical pattern in which small stocks have outgained big ones when measured over several decades.

But investors in secondary stocks will still undergo a roller-coaster ride in the meantime, as these issues remain more volatile, riskier and less liquid than their big-stock brothers. And while small stocks may outrun the blue chips, both groups may still decline if the current bear market persists.

‘Treacherous Market’

“You have to come to grips with whether this current rally is a giant suckers’ rally” in a bear market, says A. Michael Lipper, president of Lipper Analytical, echoing a concern of many market watchers who have seen the Dow industrials set post-crash highs this month. If it is a temporary rally, then many stocks--large and small--could be pummeled in the next few months, Lipper says.

“This is a really treacherous market,” says Ralph Acampora, technical analyst at Kidder, Peabody & Co., who expects a major retreat in all stocks sometime over the next year or so.

Nonetheless, arguments supporting a market led by secondary issues are abundant. Among them:

- Small stocks are cheap compared to big stocks. Simply put, it’s small stocks’ turn to lead the market, as they last did between 1977 and 1982.

Their lack of participation in the 1982-87 bull market made them undervalued versus big stocks, a condition worsened when small stocks fell farther in the October crash and the following two months.

“You are far more likely to find stocks selling at book value (net worth per share) in the small-stock sector than you are in big stocks,” says Charles I. Clough, chief investment strategist at Merrill Lynch.

- Smaller stocks don’t necessarily do worse in bear markets. That is evident from their performance in the 1978-82 period, when in some years the NASDAQ composite scored impressive gains while the Dow industrials lost value, says Yale Hirsch, a market historian and editor of Smart Money, a newsletter in Old Tappan, N.J.

- The current phase of the business cycle favors small-company stocks. The consumer sector is giving way to the manufacturing sector as the driving force of the expansion, economists say. That favors OTC stocks because proportionally more of them are in basic manufacturing and the capital goods sector than big stocks, which are more consumer-spending oriented, says A. Marshall Acuff Jr., portfolio strategist for Smith Barney, Harris Upham & Co.

- Small companies may fare better than big ones in a recession. A recession, while looking increasingly unlikely this year, nonetheless is seen as virtually inevitable in the next two or three years. Smaller companies may cope better because they are relatively less debt-laden; bigger companies have weakened their balance sheets through stock buybacks, takeovers and restructurings. Also, a recession is more likely to be felt harder by the consumer sector--more a domain of bigger companies, Merrill Lynch’s Clough argues.

- Smaller companies stand to benefit more from the weakened dollar and the resultant shrinking of the U.S. trade deficit. Until now, the primary beneficiaries of the falling dollar have been big, multinational companies, says Bruce Calvert, director of research for Alliance Capital Management, a giant New York money management firm. Their foreign operations earned profits from converting foreign currencies into dollars, while their domestic operations gained from reduced foreign competition.

But now, small companies--whose operations are primarily domestic--are beginning to regain market share from foreigners, Calvert argues. And a rising dollar will hurt multinationals because they will lose profits from unfavorable currency translations.

- Smaller companies may be the next targets of merger mania. Big companies, rather than corporate raiders, are now the main acquirers. And they may increasingly seek to acquire smaller competitors or suppliers, some analysts say.

- The public still is not a major participant in the small-stock rally. Instead, the rally is being led primarily by pension funds and other institutional investors, indicating that the secondary-stock boom may still be in its early stages, some analysts reason. Individual investors typically jump in near market peaks, not at the bottoms, they argue.

These arguments notwithstanding, small stocks still carry high risks, analysts caution.

One risk is that many small stocks may not participate in any overall rally. The advance so far has been led by the largest secondary stocks that are more widely traded and thus easier to buy and sell.

“Small stocks are OK--you just have to find the right ones,” says Merrill Lynch strategist Clough.

Another risk is the reduced liquidity in OTC stocks. Trying to minimize their risks with the memories of the October crash still fresh, many dealers in OTC issues are holding fewer shares in inventories, providing less of a role as buyers and sellers of last resort to cushion price swings. While that may have helped push OTC stocks higher this year, it may also quicken a decline.

Minimize Risks

“If there is a sudden downturn, these things could drop 25% in a day or two,” says Charles Allmon, president of Growth Stock Outlook Trust, a mutual fund that has invested heavily in smaller stocks.

“A lot of people are going to get burned on the over-the-counter market,” says Allmon, adding that “there is a lot of profit-taking potential” for OTC stocks. In fact, Allmon says he is looking for opportunities to take profits on many of his stocks.

How can you minimize risks and still participate?

Lipper of Lipper Analytical Services suggests that conservative investors should keep no more than 10% to 30% of their money in small stocks. And when buying, they should use dollar-cost averaging, a strategy to invest in installments so as to average out purchase prices.

Also, because information on small companies is harder to come by, investors without the time to research individual issues should stick to mutual funds with strong track records of investing in small stocks.

Larger secondary-stock funds performing well of late include Scudder Development, T. Rowe Price New Horizons, Acorn Fund, Fidelity OTC, Pennsylvania Mutual Fund and Nicholas II, according to Lipper Analytical data.

Most of all, Lipper advises, invest in small stocks for the long term. “If you had a trading mentality, I would not be using small companies.”