Temper Expectations, Experts Warn Investors

To some investors, the ongoing rally in small stocks must seem like a wild party that they want to join but wonder if they should. Sure, there’s the potential of having lots of fun now. But will they wake up with a hangover when it’s over?

For the second straight year, small stocks and the mutual funds that hold them are the hottest things on Wall Street. The funds vaulted 52% on average in 1991, and gained better than 7% in the first eight weeks of this year.

But anyone with a long investment memory knows that small-company funds can go down as quickly as they rise. With stock prices at high values and the economy stuck in neutral, there’s a real danger of that at the moment.

In fact, some of the pros who manage leading small-company funds are cautioning investors to temper their expectations, at least until recession-battered corporate earnings rise to levels that justify today’s lofty prices.

“Don’t expect to repeat last year’s performance,” warns Bob Czepiel, manager of the San Francisco-based Robertson Stephens Emerging Growth fund. “Money can still be made, but it’s going to be tougher.”

Alan Radlo, who runs the Fidelity OTC Portfolio in Boston, says he’s having a hard time finding good values among small companies. “A lot of stocks aren’t leaving much room for error, given their high (price-earnings) ratios,” Radlo says. He has raised his fund’s cash and Treasury bond holdings to about 20% of assets, a fairly high level for the portfolio.

Douglas Jones, who manages the Sit New Beginning Growth fund in Minneapolis, has raised his cash holdings to 14%, also at the high end of the fund’s range. Although Jones figures that it’s not the time for investors to get out, he admits that many small stocks are on the expensive side.

In Radlo’s view, the solution isn’t for investors to ignore small-company funds, especially while they’re on a roll. Instead, he says, people should invest in this volatile sector periodically and in relatively small amounts--a strategy known as dollar-cost averaging. “It’s too hard to pick the low and high prices,” he says.

It’s also wise to lean toward funds with a track record of consistently good performance--specifically in avoiding big losses. That’s not easy, since small-company portfolios as a group are more volatile than their blue chip cousins. But if you can live with setbacks of a few percentage points in a typical off-year, you may be interested in any of several funds.

For example, five small-company funds enjoy the distinction of not having lost more than 5% in any of the previous five years. That’s not bad when you consider that the group on average fell 10% in 1990.

The leader here is the Twentieth Century Ultra Investors Portfolio, the only small-company fund to have gained ground each of the past five years.

For Ultra, the challenge will be to maintain its impressive track record--it has grown tenfold, to $3.5 billion in assets, since October, 1990. Large funds, critics say, must work harder to find a sufficient number of good small stocks to satisfy their cavernous appetite for new investments.

Most small-company portfolios haven’t even been around five years, which makes them hard to evaluate. But some of these younger funds still show good potential for superior upside gains and little downside risk. The most consistent player is Robertson Stephens Emerging Growth, which has never had a down year (its worst showing was a 9.6% gain in 1990).

For investors who can stick through what could be a bumpy road ahead, there are compelling reasons to have at least some money in small-company funds. One is that there aren’t many investments with more appeal at the moment.

The funds, in short, are on a roll. And if interest rates are cut further, which Radlo considers a fair possibility, that would tend to lure more investors into equities in general, pushing up prices.

In addition, there’s the historical angle. Czepiel notes that small stocks have been outperforming large shares since October, 1990, in what could be the early stages of another long-term trend. “We’re only 15 or 16 months into the recovery of small stocks versus large stocks,” he says. “These cycles tend to last anywhere from three to nine years.”

But the main lure is the excellent profit potential of many up-and-coming companies. According to James Stowers III, who helps run Twentieth Century Ultra, profits drive stock prices, and it’s a lot easier for a smaller outfit to double its earnings compared to a giant like IBM. Czepiel agrees, and he predicts that companies both large and small will be reporting better profit results in months ahead. “Every day there’s new evidence that the economy’s on firmer ground, that the worst is over,” he says. “I think upside earnings surprises will start to dominate the news.”

Big Results in Small Packages

Mutual funds that invest in smaller stocks have a well-deserved reputation for being volatile. A handful of the better ones, however, have managed to keep risk down and returns up. The following funds are among the most consistent performers. They’ve scored above-average gains while not suffering any major yearly losses in recent years. The portfolios are divided into two categories, depending on how long they’ve been around.

Older Funds (5 years or more)

Average annual Worst gain year Minimum Sales Fund (1987-91) (1987-91) investment charge Alger Small Capitalization +25.7% -1.5% (‘87) None 5% Fidelity OTC +18.3% -4.8% (‘90) $2,500 3% Sit New Beginning Growth +20.3% -2.0% (‘90) $2,000 None Twentieth Century Ultra +27.6% +6.7% (‘87) None None

Fund Phone Alger Small Capitalization 800-992-3863 Fidelity OTC 800-544-6666 Sit New Beginning Growth 800-332-5580 Twentieth Century Ultra 800-345-2021

Alger Small Capitalization charges a back-end load that starts at 5% and phases down to zero over six years.

Younger Funds (four years)

Average annual Worst gain year Minimum Sales Fund (1987-91) (1987-91) investment charge Phone Robertson Stephens Emerging Growth +30.0% +9.6% (‘90) $5,000 None 800-766-3863 Transamerica Special Emerging Growth +25.3% -1.2% (‘90) $1,000 4.75% 800-343-6840

Source for performance results: Morningstar Mutual Funds.