Looking for a Winner Stock? Think Small
Contradictions and confusion. Interest rates are going up, but the U.S. economy is slowing down--or speeding up. High inflation may be coming back--or it may not. With the economy as uncertain as the weather, what’s the average person to do about investing money?
Experts aren’t sure. The new issue of Money magazine has five investment analysts forecasting either recession or no recession, inflation or no inflation--predictions that in any case are better suited to trading and timing than to the needs of small investors.
What average people need are long-term investments that protect them from inflation and make their money grow. And only one investment can do that: common stocks--or more realistically for small investors, stock mutual funds. “For the past 62 years, stocks have outperformed bonds and cash by a ratio of 24 to 1,” said Kurt Brouwer of the San Francisco investment firm Brouwer & Janachowski, one of Money’s analysts.
Note how specific: 62 years, 24 to 1. What’s Brouwer talking about? He’s referring to a study of long-term investment returns originated a dozen years ago at the University of Chicago. Roger G. Ibbotson, a university lecturer in finance at the time, and Rex A. Sinquefield, money manager at a local bank, developed a statistical series showing that over the long term common stocks produce a dramatically greater return than fixed-income investments.
Specifically, their work, which is updated and published annually by Ibbotson Associates of Chicago as the “Stocks, Bonds, Bills and Inflation Yearbook,” says that $1 invested in the common stocks of the Standard & Poor’s 500 index in 1926 would have grown to $347.96 at the end of 1987, while $1 invested in a theoretical portfolio of 20-year Treasury bonds, and continually reinvested, would have grown to $13.35 by year-end 1987.
Grow With Economy
The vast difference (actually 26 to 1) reflects a 9.9% compounded annual return on stocks over the 62 years and a 4.3% return on bonds, and is not adjusted for inflation. Adjusting for inflation, however, reduces the bonds’ return to less than 1% annually, while the stock return is 6.6% a year.
Thus, the historic evidence shows that common stocks stay ahead of inflation and grow as the American economy grows.
Moreover, the Ibbotson-Sinquefield study went further and found that small capitalization stocks--those where the combined value of all the shares ranked lowest on the New York Stock Exchange, the American Exchange and the over-the-counter market--outperformed the bigger stocks on the S&P; 500. Impressively so: $1 invested in small stocks in 1926 grew to $1,202.97 by the end of 1987, the study said.
No risk no reward, of course. Small stocks fell more than big ones in the October, 1987, market crash and have trailed the bigger companies since 1983 as well.
But that’s a positive signal for some people in the mutual fund business. “Any time small stocks lag for a number of years, they come back strong,” says Stanley Egener, president of Neuberger & Berman Management, which invests $14 billion for wealthy individuals, pension and mutual fund investors. Neuberger & Berman is bringing out Genesis Fund, which will specialize in “small cap” stocks. Baltimore’s giant T. Rowe Price organization is bringing out a Small Cap Value fund, and others are sure to follow.
One reason for the action is institutional investor interest. The big pension funds have a hard time buying stocks of small companies--where $20 million might buy control of the firm. So, just as they do for individuals, mutual funds can spread the institutions’ money and their risk.
Why do small stocks do better than big? Most people would think it’s because they are the proverbial “next Xerox,” the new idea or new technology. But that’s not true, says Rex Sinquefield, author of the study and now chairman of Dimensional Fund Advisors in Santa Monica. “The success is mostly in low-tech companies, and if people think only of high technology, their investments are likely to be too concentrated and risk disaster.”
Sinquefield’s fund company, which doesn’t research individual stocks but buys them all, has $3.5 billion invested in 4,000 U.S. small companies and about $500 million invested in 2,000 foreign companies. Small stocks outperform big ones in Japan and Europe, too.
Experts “simply do not know why small stocks do better, although one can conjecture,” says Sinquefield. “They are riskier than big companies”--in bad times they fall harder and faster. Sinquefield’s funds have 20 or 30 companies in bankruptcy at any one time. Which means, of course, that the survivors could be the products of a natural selection, fitter small outfits, more capable of producing high returns than big companies.
Whatever the reason, the statistical evidence is reassuring: that if one avoids the clamor and confusion, there are ways to make a pretty good buck investing in the American economy.
