Small Stocks Can Mean Trouble for Naive Investors
Everybody wants to own small stocks again because small companies’ earnings are going to be far better in the 1990s than they were in the 1980s. Right?
Well, at least the first part of that equation is correct: The 38% jump in the NASDAQ index of 4,000 small stocks since mid-January has been driven largely by perceptions of a major turn in the companies’ prospects.
But if small companies are on the verge of minting money for their shareholders, they didn’t make much of a start in the first quarter. And some small-stock experts are nervously questioning what has already become gospel among many investors--that small firms’ profits will grow faster than big companies’ profits in the ‘90s, reversing the pattern of the past 10 years.
The accompanying chart illustrates just how bad small-company earnings performance has been since mid-1988. It compares profit growth of 900 small firms tracked by Prudential Securities with results of the big, household-name firms of the Standard & Poor’s 500 index. The awful truth:
* In nine of the 10 quarters since mid-1988, small-company earnings rose less (or fell more) than earnings of big companies.
* Using an even broader index of small stocks, the Russell 2,000, small-firm earnings declined in six of the nine years ending in 1989. S&P; 500 earnings fell in only three of those years.
In the first quarter of this year, while small stocks were roaring ahead, the companies continued to disappoint on the earnings front. Prudential analyst Claudia Mott says that of 560 small companies in her universe that have reported first-quarter results, 30% have been worse than expected, while only 15% have been better than expected. Overall, the firms’ earnings are down 14% from the first quarter of 1990.
Granted, there’s a recession going on. Investors don’t seem to care much about the first quarter. But they do expect that small companies will break out of their profit slump over the next few years. Otherwise, why should the stocks be up so much? “Stock prices come first, and earnings come later,” is how Mott describes investors’ collective attitude.
But if you ask small-stock experts this simple question--”What’s going to cause small-company earnings to turn around?”--you are more likely to get a litany of reasons why big companies will do less well than why small companies will do better. In other words, small companies are largely viewed as winners by default.
For example, John Laporte, a veteran small-stock authority at mutual-fund firm T. Rowe Price Associates in Baltimore, expects the economic recovery--when it comes--to be muted. “That’s an excellent environment for small growth stocks, particularly when you overlay that with a stronger dollar,” he says.
Why? Because big companies make money by doing volume business, and volume is expected to be harder to achieve in the years ahead. Also, if the dollar continues to rise in value versus other currencies, multinational firms’ overseas profits will be squeezed, because foreign profits will be worth less when translated into dollars. (It was the dollar’s slide in the ‘80s, remember, that artificially boosted profits of big companies.)
OK, those are two ways that small firms may indeed win by default for a while. On the other hand, most Wall Streeters also expect inflation to remain low in the ‘90s. And historically, small firms have had a much tougher time in low-inflation periods than in high-inflation periods, because they can’t raise prices as easily.
Perhaps most troubling of all is simply that few experts seem able to address why small-company earnings in the ‘80s were so bad in the first place. Poor results from emerging technology companies certainly dragged the aggregate earnings figures lower. So, too, did the restructurings many small companies undertook to slim themselves down.
Still, there are many small companies in many different businesses that struggled to make a buck for much of the last decade, for reasons that have not been well explained. Investors, in wildly bidding the stocks up this year, suddenly appear convinced that that struggle is over. But in a world economy certain to become even more competitive in the years ahead, there’s no reason to believe that small firms’ fight to survive will be any easier.
“I don’t see any magical reason why small-company profits overall are going to be better in the ‘90s than in the last seven years,” warns Jim McCamant, who has chronicled the fortunes of many small stocks in his Berkeley-based Medical Technology Stock Letter.
What’s a small-stock investor to do? Just this: Don’t hop aboard a small stock merely because it looks cheap. At some point, probably sooner than later, earnings are going to count. And if the company has had trouble delivering in the past, and nothing has changed, the stock is likely to go down as quickly as it has run up.
Mark Matheson, research chief for small-stock brokerage Cruttenden & Co. in Newport Beach, says the key to making money in small issues from here out will be to find those companies that truly have great products or services for the ‘90s, “and to hang on until everyone else can see what you see.”
As a group, small companies’ ability to produce strong profit growth may not be greater now than before, Matheson says, but the new focus on small stocks at least assures that “more people are going to pay attention” when a small company does deliver.
