In the Domestic Economy, Small Stocks Earn a Closer Look
In the hunt for hot stocks on Wall Street, the preferred tool has shifted from elephant gun to magnifying glass.
Small-company stocks, which have lagged their big-company, blue-chip rivals for the last two years, now are the clear market leaders--and could stay that way for some time, some investment pros say.
On Tuesday the small-stock rally pushed ahead, with the Russell 2,000 index of small issues rising 2.43 points, or 0.7%, to a record-high 343.52, outpacing gains in blue-chip indexes. Since March 15, the Russell index has jumped 5.7%, while the blue-chip Standard & Poor’s 500 index is up just 1.6%.
That’s a big change from 1994 and ’95. Blue-chip stocks dominated the market in both years as interest rates first soared, then tumbled, causing the U.S. economy to sputter. Many investors sought safety in big-name stocks like Exxon, PepsiCo and General Electric, companies whose overseas growth offered a hedge against problems in the domestic economy.
In 1994, the Russell 2,000 index fell 3.2% in price; the S&P; 500 lost half as much. And in 1995, the S&P; rocketed 34.1%, its best calendar-year gain since 1958. The Russell index lagged in 1995, though it still gained a respectable 26.2% (28.4% including dividends).
This year, the surprising strength of the U.S. economy is what’s luring investors back to smaller issues at blue chips’ expense. Smaller companies, which after all make up the majority of U.S. stocks (something people often forget), generally depend heavily or exclusively on U.S. sales. So if the domestic economy is picking up, smaller companies often notice it first and foremost.
Indeed, the leading stock group so far this year in Prudential Securities’ universe of 1,120 smaller companies is “consumer discretionary,” where the average stock was up 14.3% through Friday. The group includes smaller retailers, restaurants and leisure-time companies that are almost totally dependent on the U.S. consumer.
Technology issues, while perhaps the group that people think of first when the term “small stock” is mentioned, have gained this year, but are only the sixth-best small-stock industry group in Prudential’s universe. What that suggests is that interest in small stocks this year is quite broad--potentially a healthy sign for the rally.
Beth Dater, a veteran small-stock picker who co-manages the Warburg Pincus Emerging Growth fund in New York (up 8.4% so far this year), argues that the stock market’s ability to bounce back from declines sparked by rising bond yields in March indicates that investors are hungry for growth companies and are less focused on interest rates’ gyrations. “If the focus is going to be on earnings growth, that’s good for smaller companies,” she says. Or at least, it’s good so long as the U.S. economy remains on a decent growth track.
Prudential’s small-stock analyst, Claudia Mott, believes many smaller companies have better earnings growth prospects this year than they’ve had in several years, assuming a resilient domestic economy. At the same time, she notes some blue-chip multinational firms may face a challenge to earnings because of the dollar’s strength, which can devalue profit generated overseas.
But Mott warns against betting on dramatic gains in smaller stocks as a whole. The 50%-plus annual price appreciation often associated with small-stock bull markets generally occurs only after recessions, when the economy rebounds sharply and companies enjoy terrific sales and earnings leverage, Mott notes.
Still, she says, small stocks have a good shot at continuing to outrun blue chips this year.
For investors who want to own small stocks via mutual funds, here are some tips:
* First, realize that you may already be an owner. Many mutual funds that don’t specifically advertise themselves as small-company funds own plenty of them. The typical growth-stock fund, for example, often holds a generous helping of smaller stocks because those are usually the fastest-growing firms. The very definition of small stock varies widely, but typically includes all companies whose market value (stock price times number of shares outstanding) is below $1 billion. That’s most stocks.
* Under the specific category of “small-stock funds,” fund-tracker Lipper Analytical Services counts 383 funds. You can pick from among small-company “value” funds (they typically own shares of older, less risky businesses that are judged to be undervalued by the market) and small-company growth funds (which usually focus on very young, high-growth but also higher-risk firms).
Some small-company funds are hybrids, mixing both growth and value issues. Your tolerance for risk should determine how aggressive you want to be. Remember: Smaller stocks are much more volatile than bigger stocks, and in bear markets you can expect to see your small-stock fund lose much more than a blue-chip fund would. The payoff comes in hot markets, especially early in bull markets, when smaller issues far outrun bigger stocks.
* If you want to go with experience--perhaps not a bad choice this far into a bull market--here are some of the veteran (at least 5 years old) small-stock funds that rate highly according to fund-tracker Morningstar Inc. in Chicago: Columbia Special, Fidelity Low-Priced Stock, MFS Emerging Growth, Seligman Frontier and T. Rowe Price New Horizons.
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Laggards to Leaders
The small-company stocks leading this year’s rally are those that lagged badly last year: “consumer discretionary” businesses such as retailers and restaurants, and certain basic-material and manufacturing firms. Those sectors benefit from a stronger U.S. economy. small-stock sector performance, 1995 and year-to-date through last Friday:
*--*
1995 1996 Industry sector return gain* Consumer discretionary +9.8% +14.3% Basic materials +14.3 +14.2 Energy (general) +36.5 +12.4 Conglomerates +24.3 +11.7 Autos and transportation +8.2 +8.7 Technology +48.7 +8.4 Health care +40.7 +6.7 Capital spending +32.5 +4.2 Financial services +38.9 +2.3 Utilities +24.1 +1.4 Consumer staple goods +20.1 -1.4 Integrated oil -0.8 NA Russell 2,000 index +28.4 +7.1
*--*
* price change only; 1995 data includes dividends.
NA: not available
Source: Frank Russell Co.; Prudential Securities
