Smaller Stocks May Be Ready to Play Catch-Up

If blue-chip stocks are about to take a rest, Wall Street is hoping that laggard smaller stocks are ready to take a bow.

The recently streaking Dow Jones industrial average finally suffered a little profit-taking on Tuesday, losing nearly 80 points, or 1.2%. But the selling wave, which struck late in the day, didn’t spill into the market of smaller stocks.

In fact, the Russell 2,000 index of smaller shares gained 0.7% for the day, continuing its uptrend of the past week.

Smaller stocks, the nebulous term that encompasses almost all but the 500 or so biggest U.S. companies, have generally been left in the blue chips’ dust since the stock market’s sharp pullback in July. While the 30-stock Dow surged 17% from Aug. 1 to its all-time high of 6,547.79 on Nov. 25, the Russell 2,000 index rose 10% in that period.


And year to date, the Russell index’s total return (including dividends) was just 13.5% through last Friday, versus 25.5% for the Standard & Poor’s 500-stock index of big-name issues.

Everybody on Wall Street has a theory about investors’ general aversion to smaller-company stocks since summer, of course: People wanted to play it safe after the market’s July tumble, so they’ve stuck with the mighty Coca-Colas, General Electrics and IBMs; the U.S. economy looks iffy in 1997, and smaller companies tend to be more dependent on the domestic scene; and new Nasdaq trading rules to take effect in January will make it less profitable for brokers to trade smaller shares, so the stocks could become more volatile.


All of the above may be true. But what’s also true, historically, is that December and January are good months for smaller stocks. So as the Russell index has performed better than the Dow over the past week, some pros have begun to sense that the tide is turning in favor of smaller stocks.


Claudia Mott, small-stock analyst at Prudential Securities in New York, notes somewhat cynically that “there’s been so much press about lagging smaller stocks, [a rally] could become a self-fulfilling prophecy now.”

But many analysts also argue that there are good fundamental reasons for investors to start shopping again among smaller issues. For many of the companies, their stock prices haven’t kept up with earnings growth this year--which means that the stocks’ current price-to-earnings ratios may in many cases be in bargain territory, especially compared with P/Es of 20 or higher on blue chips.

Jeffrey Adams, manager of the Seven Seas Small Cap fund in Boston, says his portfolio’s average P/E based on the stocks’ estimated earnings over the next four quarters is about 14--which is below the 15%-to-20%-or-better earnings growth he expects from many of his companies.

If you buy the idea that smaller stocks are ready to do some catch-up, which sectors look most attractive? Bill Keithler, manager of the Berger Small Company Growth fund in Denver, says he finds many smaller technology issues appealing, particularly in the still-battered semiconductor area. Smaller retailers “also are getting interesting again,” he says. And the depressed health-care sector has had such a bad year in 1996, “you almost have to believe that 1997 is going to be better for the stocks,” he says.

Some experts suggest that the smartest play today among smaller stocks is in “mid-capitalization” issues, companies in between blue chips and truly small stocks. Keith Mullins, growth-stock analyst at Smith Barney in New York, believes that if institutional investors begin moving out of some of their blue-chip names, they’re more likely to move into reasonably liquid mid-cap names like retailers Tiffany and CompUSA, and tech issues like software firm Informix, than into much smaller stocks that were hammered in the summer slide.

(If you own a mutual fund that invests in smaller stocks, now is a good time to check whether its focus is on very small issues or on mid-cap issues.)

Finally, however optimistic many pros are about a smaller-stock bounce here, most say it will only happen if blue-chip stocks hold up reasonably well, or decline gently as investors take profits.

“If we get a sharp decline in the Dow, smaller stocks are going to be road kill,” Mullins warns.



What’s Hot, and Not

A few sectors of the small-stock market have turned in stellar returns this year, but most have lagged the blue-chip Standard & Poor’s 500-stock index. Performance of stock industry sectors within the Russell 2,000 small-stock index, total returns through Nov. 30:

Energy (misc.) +68.3%

Integrated oil +29.2%

Financial services +22.3%

Consumer discretionary +17.9%

Other +15.8%


Auto/transportation +13.2%

Materials and processing +12.9%

Consumer staples +12.1%

Producer durables +10.3%

Technology +9.5%

Utilities +1.1%

Health care -10.2%

Russell 2,000 index +13.5%

S&P; 500 index +25.5%

Source: Frank Russell Co.