Small Stocks Aren't Exactly Batting 2,000

By RUSS WILES

April 13, 1997 12 AM PT

Russ Wiles is a mutual fund columnist for The Times

Small-stock mutual funds have performed so poorly in recent months that you have to wonder whether the whole high-risk/high-return theory has broken down.

That’s the one asserting that more volatile investments should deliver better results over time.

Small-stock funds badly lagged growth-and-income ones during the first quarter of 1997, says Lipper Analytical Services of Summit, N.J. They also trailed over the one-, two- and three-year periods ended March 31, as well as in the five-, 10- and 15-year stretches.

Relative to large-stock funds, small-company portfolios appear to be trading at bargain prices these days.

“You’ve got strong earnings growth [among small corporations], and the relative valuations are very attractive,” says Aash Shah, portfolio manager of the Federated Small-Cap Strategies Fund in Pittsburgh.

Small stocks, such as those in the Russell 2,000 index, are selling at roughly the same price-to-cash-flow levels as those of large companies in the Standard & Poor’s 500, Shah says, adding that this has not happened since 1979.

Small stocks also are trading at slightly lower price-to-earnings ratios than large companies--another rarity.

“Normally, the Russell 2,000 trades at a 30% P/E premium to the S&P; 500,” says Louis Navellier, manager of the Reno-based Navellier fund family, which is oriented toward small stocks.

Navellier expects companies in the Russell 2,000 to generate twice the earnings growth this year of big stocks in the S&P; 500.

Nobody doubts that small-company mutual funds are riskier than large-company funds, based on the types of companies each group holds. So why haven’t they performed better?

Observers say the following factors have hurt small stocks and small-company funds relative to their larger brethren:

* Foreign investors. Cash has been flowing into the U.S. stock market from abroad, thanks in part to the strong dollar, which can enhance the returns that foreigners can earn. What foreigners buy are the stocks they recognize--the big blue chips.

* Downsizing. Large companies have benefited more from layoffs and restructurings, partly because they had more employees or underutilized divisions to cut, and thus greater leeway to increase their earnings.

* Interest rates. Large companies are more credit-worthy than small firms and thus make greater use of borrowing to grow.

“Small companies don’t borrow money, because they can’t,” says A. Michael Lipper, president of Lipper Analytical. Therefore, big corporations have been the main beneficiaries of the low-interest-rate cycle of the last decade.

* Indexing enthusiasm. Many investors have become convinced that the best way to ensure not getting left behind in a rally is to invest in the same stocks that make up popular indexes. Most index-fund cash has flowed into the S&P; 500, boosting prices of its component large stocks. Small-company indexing is less widespread, for reasons related to market inefficiencies and higher trading costs.

Some market watchers say that rules being phased in this year regarding the visibility of Nasdaq quotes are also playing a role in depressing small stocks, at least temporarily. The rules make it harder for investment dealers to earn wide spreads, or profits, on the stocks in which they make a market. Investors tend to regard stocks with fewer market makers as more risky.

“Today, there often are no spreads on certain stocks, reducing the enthusiasm for firms to serve as market makers,” Navellier says.

It’s also worth noting that the Lipper figures showing the dominance of large-stock funds encompass two favorable cycles for them. Large stocks were hot from 1983 through 1990 and have outperformed from 1994 on.

Small companies did better from 1991 through 1993. They also outperformed from 1973 to 1983,

which shows up in longer-term Lipper numbers. Over the 20 years ended March 31, small-stock funds handily beat their large-company rivals.

What’s needed today to generate more enthusiasm for small stocks? Navellier and Shah think that when leading large corporations eventually report lackluster earnings, that will put smaller firms, with their greater profit potential, into the spotlight.

“It will take a crack in a bellwether stock like Coke, Merck or GE,” Shah says. “And if you move out of a Coke, you may have to buy four or five small stocks to reinvest the same amount of money.”

It’s also possible that large companies have already reaped most of the available benefits from trends such as downsizing.

That said, there’s no way to tell when the tide will turn. Small companies and small-stock funds could stay depressed, relatively speaking, for quite a while.

That’s why Lipper suggests that investors maintain permanent stakes in various types of stock funds--those targeting large, small and foreign companies--with each group further broken down into growth and value stock-picking styles.

“Each of these areas should be represented within a portfolio,” he says.

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Small Isn’t Better

Mutual Funds that invest in small companies have not kept pace with large-stock funds over recent periods, but if you look at 20-year trends, they are ahead.

SMALL-STOCK

Quarter: -6.9%

1 year: +4.67%

2 years: +37.14%

3 years: +46.73%

5 years: +87.01%

10 years: +195.09%

15 years: +633.19%

20 years: +1,718.28%

LARGE-STOCK

Quarter: +1.13%

1 year: +15.47%