Day for Small-Company Stocks May Be Near

Like Dust Bowl farmers, investors in small-company mutual funds have been waiting for their own drought to end.

Lately, there have been signs that the long dry spell could be breaking. But many investors seem reluctant to jump on the bandwagon just yet, considering that there have been other false signals in recent years.

During much of the 1980s, mutual funds that invest in smaller corporations assumed the unfamiliar role of laggards. As a group, they posted an average total return of roughly 64% over the five years ending March 31, according to Lipper Analytical Services. That’s well below the 92% increase for equity funds in general over the same period. This sort of under-performance is unusual because small-company shares typically appreciate at an above-average rate.

Reflecting this potential, investors usually have been willing to pay “growth premiums” for small stocks in the form of higher price/earnings multiples. But no more.

The T. Rowe Price New Horizons Fund, considered a proxy for the small-company market, in late March sported a P/E of 14.8--the same as for Standard & Poor’s 500-stock index, a blue-chip bellwether. Only one other time in the past 30 years has New Horizon’s relative P/E fallen this low, says Kenneth D. Waggoner, a spokesman for T. Rowe Price in Los Angeles. Usually, the fund’s multiple hovers at about 1 1/2 times that of the S&P; 500, and occasionally it has exceeded 2 times.

Lately, small-stock enthusiasts have been buoyed by indications that the tide could be turning. Since mid-May, the NASDAQ over-the-counter composite index has risen more than the S&P; 500. Concurrently, the NASDAQ index pushed above its 200-day moving average for the first time in three months--a bullish factor in the minds of many market watchers.

Small-company funds typically don’t invest in truly tiny corporations but rather in OTC firms whose shares outstanding are worth $200 million to $400 million or so.

Does this mean stock market momentum is rotating away from the blue chips? The people who run leading small-company mutual funds disagree.

Beth Cotner, portfolio manager of the Kemper Summit Fund in Chicago, isn’t convinced that the rally of the past few weeks suggests a new trend of better performance for small issues. “Most of the recent strength in the over-the-counter market has been related to technology stocks,” Cotner says. She’s awaiting an upsurge involving many industry groups.

But Steve Barry, one of three portfolio managers for the Alliance Quasar Fund in New York, believes that the rally has been broad enough to suggest that a turning point is near. “We’re in the process of bottoming on small stocks,” he says.

Chuck Royce, who has run the Pennsylvania Mutual Fund for the past 17 years, agrees. “This is definitely the beginning of something,” he declares. Given the relative strength of large stocks from 1984 on, Royce believes that the law of averages are on his side. “Small companies outperform on a cumulative basis over long periods,” he says. “That’s been true for most 10-year periods and all 15-year periods” dating to the 1920s.

What would it take for small stocks to emerge again as market leaders? For starters, investors as a group would have to show a preference for earnings growth rather than “values.” In other words, they would have to place a premium on companies with superior profit potential rather than undervalued assets. If the decline in takeover activity since last fall is an indication, this might be happening.

Also, the public would have to get excited about stocks again. Individuals tend to be the most significant buyers of many smaller issues, simply because banks, pension funds, mutual funds and other institutional investors can’t. “Institutions have so much money to invest, they have to buy large companies so as not to disrupt a stock’s price,” explains Geraldine Weiss, publisher of Investment Quality Trends, a La Jolla newsletter.

However, many people are reluctant to buy stocks, given the greater perceived volatility of recent years. For small issues to outperform bigger ones, “you would need individuals to come back into the market in greater numbers,” Weiss says.

Add purchases by foreign investors, who tend to prefer large U.S. companies with which they’re familiar, and you can see why blue chips have been in vogue in recent years.

Weiss predicts that more smaller investors will return to the stock market. But she believes that the change will be gradual, perhaps stretching out over several years.

In general, small-stock funds are considered to be more risky than the average equity portfolio because the issues they hold are more erratic. Consider, for example, the recent volatility of Adobe Systems Inc. When the computer software firm announced lower-than-expected earnings May 24, Adobe’s stock the next day tumbled more than $15 a share to close at $35.25.

Of course, mutual funds typically hold dozens if not hundreds of issues, so they can absorb steep drops in individual stocks. Even so, there will be bumps along the way.

To put the long-term averages to work in your favor, Royce recommends holding a small-company fund for many years and purchasing shares by “dollar cost averaging.” This way, you invest a set dollar amount in a fund each month, with the result that you tend to buy fewer shares when prices are high and more shares when prices are low.

But what if you don’t have a long-term horizon or simply can’t stomach much volatility? Walter Rouleau, publisher of the Growth Fund Guide newsletter in Rapid City, S.D., suggests that you determine, at the time you invest, how big a loss you’re willing to accept--say, 10%. If the fund declines by that magnitude, you sell. If the fund rises after you buy, you simply move up your sell point so that it stays 10% below the current price.

This loss-limiting method has drawbacks. It implies that you will never sell at a top price. Also, it requires discipline on your part. On the other hand, following this approach could save you from a portfolio-shattering drop. “If the market gets hit hard, some small-stock funds will take it on the chin,” Rouleau says.

Of course, blue-chip stocks can also fall sharply, which is why Waggoner recommends holding more than one type of equity portfolio. “Two separate markets seem to have emerged--one for institutions and one for individuals,” he says. “That implies that you could get some diversification benefit from holding a blue-chip fund along with a small-company fund.”

LEADING SMALL-COMPANY FUNDS

While smaller stocks can be quite volatile over the short term, they tend to outperform their larger brethren during periods of several years or more. The same goes for mutual funds that invest in these companies.

This table illustrates the profit potential of leading small-company funds for people who can afford to keep their money invested for many years. Each of the portfolios listed has beaten the group’s average gain for the past five, 10 and 15 years.

Notably, the period since 1984 has been substandard, at least compared to larger issues. For this reason, small stocks might be ready to lead the market in coming years, some observers believe.

TOTAL RETURN Sales Minimum Fund 15 years 10 years 5 years fee purchase

Acorn +1,568% +414% +118% None $4,000 (800-922-6769)

Alliance Quasar +2,066% +527% +112% 5.5% $250 (800-221-5672)

Hartwell Emerging Growth +1,310% +407% +144% 3% $2,000 (800-845-8406)

Kemper Summit +1,096% +343% +75% 8.5% $1,000 (800-621-1148)

Pennsylvania Mutual +1,918% +522% +86% None $2,000 (800-221-4268)

Small-Company Funds Average +1,003% +308% +64%

All Equity Funds Average +774% +341% +92%

Note: Acorn charges a 2% fee on shares redeemed within the first 60 days. Pennsylvania Mutual charges a 1% fee on shares redeemed within the first year. Alliance Quasar charges a 12b-1 fee of 0.3% a year.

Total return is for periods ending March 31, 1990; provided by Lipper Analytical Services.

HOW MUTUAL FUNDS PERFORMED

Average total return, including dividends, in percent for periods ended Thursday, May 31

TOP 10

Fund Type Notes 12 mos. Yr. to date Week Equity Strategies S NL 52.24% 32.20% 11.59% Schield: Progressive S L * 28.40* 5.42 Environment Fidelity Select Energy Service NR LL,R 54.11 18.77 4.40 Sherman, Dean Fund CA NL 4.84 -10.80 3.83 GAN: North America CA L ** -2.27 3.45 Mutual of Omaha Growth Fund G L 39.1 19.67 3.08 American Investors Growth Fund G L 17.42 11.1 2.87 Alliance Global: Canadian IF L -5.87 -11.52 2.67 Strong Discovery Fund CA LL 10.27 5.56 2.45 Concord Fund G NL -1.5 3.90 2.43

BOTTOM 10

Fund Type Notes 12 mos. Yr. to date Week Seligman Commun. & Info. TK L 18.84% 13.56% -2.30% CGM Capital Development G NL 19.54 16.22 -2.20 Tyndall-Newport: Tiger Fund PC L 13.00 1.98 -1.92 AFA: Natl. Telecom. & Tech. TK L 4.75 6.32 -1.75 Alliance Technology TK L 11.48 19.95 -1.72 Zweig Ser. Trust Emerg. Grth SG L 14.11 12.04 -1.70 Schield Portfolio: Value G LL -7.65 -3.80 -1.63 Princor Aggressive Growth Fund CA L 5.42 5.11 -1.62 Flag Investors Emerging Growth SG LL 3.55 0.52 -1.60 Strong Income Fund FI NL -9.68 -4.9 -1.33

TYPE: AU = gold, B = balanced, CA = capital appreciation, CV = convertible securities, EI = equity income, EU = European regional, FI = fixed income, FS = financial securities, FX = flexible portfolio, G = growth, GI = growth and income, GL = global-international and U.S. stocks, GX = global flexible portfolio, H = health/biotechnology, I = income, IF = international, MI = mixed income, NR = natural resources, OI = option income, PC = Pacific regional, RE = real estate, S = specialty/misc., SG = small company, TK = science and technology, UT = utility, WI = world income.

NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply.

* Fund established Feb. 1990

** Fund established Jan. 1990

Source: Lipper Analytical Services