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Time for a Turn? : Smaller Stocks Are Outracing the Blue Chips, Raising Hopes

Stop me if you’ve heard this one before: Small stocks might be poised to outperform big stocks for an extended period.

That hopeful line has become something of a joke over the last two years, as blue-chip shares have rocketed while smaller shares have consistently lagged behind.

The joke turned downright ugly in the spring market slump, when many small stocks plummeted.

But look who’s laughing now: Since April 25, when the Russell 2,000 index of small stocks bottomed at 335.85, it has zoomed about 15%, to a record 387.90 now.

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In contrast, the blue-chip Standard & Poor’s 500 index is up 13% in that period, also to new highs.

Moreover, small stocks’ performance has continued to improve in recent weeks. The Russell index has gained 6.2% since May 16, while the S&P; is up 4%.

Even so, 1997 still looks like the year of the blue chip--for the third straight year. The S&P; is up nearly 17% since Jan. 1, more than double the Russell index’s gain.

Not that small-stock fans can’t find very good reasons to recommend that sector now. Goldman, Sachs & Co.'s Abby Joseph Cohen, perhaps the most trusted stock strategist on Wall Street these days, last week reiterated that she believes small-company stocks are overdue for a sustained rebound.

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“Relative valuation favors the smaller issues” over the blue chips, Cohen said. In other words, with the average blue-chip stock priced at about 21 times the most recent four quarters’ earnings per share, Cohen can find plenty of smaller stocks trading for far lower price-to-earnings ratios.

But she also admits that that has been the case for quite a while. For numerous reasons, investors have been ravenous for a select group of blue-chip shares over the last 2 1/2 years, while showing scant attention to many smaller stocks--which, of course, make up the vast majority of stocks in the market.

Big-name stocks have offered liquidity, seemingly low “event” risk (the odds of something bad happening to the company), the allure of being global franchises and strong earnings growth.

Small stocks, by contrast, often are thinly traded and have high event risk. Most important, the earnings growth posted by many small and mid-size companies over the last year or so hasn’t been fast enough to draw investors’ attention away from blue chips.

In fact, in the first quarter of this year, operating earnings for the Russell 2,000 companies were up 10%, on average, from the year-ago quarter, while operating earnings of the S&P; 500 companies rose more than 12%, according to analyst Claudia Mott at Prudential Securities in New York.

Despite their stocks’ relatively low price-to-earnings ratios, smaller companies will have to begin generating better earnings growth than blue-chip companies to keep the current small-stock market leadership alive, Mott said.

“Earnings growth [at small companies] in the second quarter is going to have to hold up pretty well compared to the large-cap companies,” Mott said. “That’s the next hurdle.”

Walter Murphy, technical market analyst at Merrill Lynch & Co. in New York, warns that it isn’t unusual for small stocks to snap back quickly from a deep sell-off, like the spring market decline.

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But sustaining that rebound is another matter, he said. Usually twice in each calendar year, Murphy notes, small stocks begin to outperform big stocks. Since 1994, however, all of those attempts at leadership have quickly failed, and blue chips have remained the smarter investment, on balance.

Still, many investment pros argue that some portion of your stock portfolio--20% to 40%, depending on your willingness to take risk--should always be in small-company stocks. Smaller firms are, after all, a key sector of the U.S. economy. And just because things look so rosy today for blue-chip multinationals doesn’t mean that will always be so.

More important, when smaller stocks really begin to outperform bigger stocks, the former often move up explosively. If you’re not already in, it can be easy to miss out on a major part of the move.

If you want to buy into the small-stock sector today, the easiest way is via mutual funds that target those shares. The accompanying chart includes two lists:

* If you want to play the “momentum” game--that is, you want to buy into the small stocks that are rising the fastest--the first list shows the small-stock funds that have rebounded the most since the April 25 low in the Russell 2,000 stock index.

That doesn’t mean these funds will continue to surge, of course. And note that some were hammered so badly in the spring downturn that they still show negative returns year-to-date, despite their sharp rebounds.

* A somewhat safer strategy: Buy into a small-stock fund that has been around the block a few times, so to speak. The second list shows some of the most popular small-stock funds in terms of asset-size. Notice that six of the 10 have performed better than the average small-stock fund this year.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

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LEADERS IN THE SMALL-STOCK FUND RALLY

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April 24 to Year-to-date Fund Thursday to Thursday Stagecoach Small Cap A +24.9% +1.5% Oberweis Emerging Growth +24.0% -5.4% Keystone Hartwell Emerg. Growth A +23.7% +3.5% UAM: Sirach Special Equities +22.6% -0.8% Ret. System: Emerging Growth +22.5% +2.3% TCW/Dean Witter Small Cap Growth +22.3% -6.6% Lancaster: Crest SmallCap +21.9% +2.8% Van Wagoner Emerging Growth +21.8% -12.0% Flag Investors Emerging Growth +21.7% +7.3% Norwest: Small Stock A +21.5% +3.4%

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POPULAR SMALL-STOCK FUNDS (BY ASSET SIZE)

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April 24 To Year-To-date Fund Thursday To Thursday PBHG Emerging Growth +20.4% -9.0% Putnam OTC Emerging Growth A +20.4% -2.9% Baron Asset +15.6% +9.6% Kaufmann Fund +14.8% +2.6% T. Rowe Price New Horizons +14.6% -2.3% Vanguard Index Small Cap +14.0% +7.2% DFA Group Small Cap Value +11.9% +10.5% Heartland Value +10.9% +9.5% Acorn Fund +10.6% +7.3% Fidelity Low Price +9.0% +8.8% Average small stock fund +14.7% +4.5% Russell 2,000 stock index +14.6% +6.2%

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Note: Where multiple share classes exist, only class A shares are ranked.

Source: Lipper Analytical Services Inc.


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