Questioning Small Caps’ Status as a Core Buy

For as long as the experts have professed the importance of asset allocation--maintaining the right investment “mix”-- they’ve argued that small stocks need to be a permanent fixture in anyone’s core portfolio.

Not only do small stocks diversify a portfolio, but over time they’re also supposed to give it a significant boost. The oft-quoted statistic is that over the last 73 years, small stocks-- although volatile--have delivered greater returns than blue-chip stocks.

But after five downright disappointing years--now going on six, with the average small-stock mutual fund again losing money in the first quarter of 1999--is it time to change the way we think about this asset class, at least in terms of mutual funds?

A growing number of investors are beginning to say yes.

Take Laurence Goldstein. The Westwood resident, who is 66, dutifully invested in small-stock mutual funds in recent years to diversify his portfolio. But inevitably his small-stock funds either lost money or earned far less than his blue-chip funds.

“Every time I’d go into them and hold them, I’d ask myself: ‘Why am I doing this? I’ve got all these other funds that are doing just fine,’ ” he said. “ ‘Why am I putting up with this?’ ”

Today, Goldstein barely does. Less than 5% of his portfolio is invested in small stocks. Does that mean he’s giving up on these stocks altogether? No. Just on the notion that he has to own small stocks at all times.

In the meantime, money that Goldstein otherwise would have invested in small-stock funds now is invested in several technology stock funds. They’ve boosted his portfolio in a way his small-stock funds couldn’t. Argues Goldstein: “Technology is not going away.”

The idea of stripping small stocks of their “core” status, and perhaps slapping that tag on tech stocks instead, is certainly a controversial one. Some say it’s premature. Others say it’s too risky.

Small stocks, after all, make up the majority of U.S. stocks. One generic definition of “small” is any company whose market capitalization--stock price times shares outstanding--is less than $1 billion. By that definition, all but 1,000 or so of the 10,000-plus U.S. stocks are technically “small-cap stocks.”

To ignore mutual funds that own those companies would seem to be ignoring a lot of investment opportunity. Yet the idea is catching on.

“We really have to think about this,” says Alan Skrainka, chief market strategist for brokerage Edward Jones & Co. in St. Louis. “Maybe our approach should change a little bit, because the economy is changing.”

Two numbers tell the story: Over the last five years, the blue-chip big-stock Standard & Poor’s 500 index generated a total return of 220.5%. In that same period, the Russell 2,000 small-stock index gained just 58.4%.

It hasn’t always been this way. As recently as 1991 through 1993, the average small-stock mutual fund was performing substantially better than the S&P.;

And since 1926, small stocks have generated average annual returns of 12.4%, according to Ibbotson Associates in Chicago. The S&P; 500, by contrast, has gained 11.2% in the same period.

That’s one reason why Ibbotson senior consultant Mike Coultrip insists that “small caps do hold a place in your core portfolio.”

But many are beginning to question the historical data.

Take away just three of the 73 years--1933, 1943 and 1967, each of which saw small stocks rise more than 80%--and large stocks have outperformed small stocks, Skrainka notes.

As for the early-’90s small-stock rally, some analysts say that may have been the final period before the environment for small-stock investing changed considerably, perhaps permanently.

In 1990, for instance, the majority of small-company stocks weren’t followed by even a single Wall Street analyst. And there were fewer than 100 mutual funds that specialized in small stocks, according to Chicago-based fund tracker Morningstar.

Today, 98% of all companies in the Russell 2,000 index are covered by at least one analyst, and the average company in the Russell is tracked by five.

What’s more, there now are nearly 400 funds that specialize in this asset class.

The upshot for small-stock fund managers is that it’s far harder to find “inefficiently” priced small stocks today than it was before Wall Street began paying attention to this sector. And that limits the opportunities for future outperformance, analysts say.

Perhaps more important in terms of fund performance is that small-stock fund managers are handcuffed in a way that managers of large-stock funds and other funds are not.

“If you’re a small-cap manager and you own a company like Cisco [Systems] at its infancy, there comes a point in time when you have to unload it because it becomes so successful that it ceases being a small-cap stock,” Skrainka notes.

In other words, whereas large-stock fund managers can hang onto all of their winners forever, small-stock fund managers may be forced to sell their best ideas just as they’re becoming most profitable, putting that cash instead into much riskier up-and-comers.

The result is that a small-stock manager may “end up exporting winners and importing losers,” Skrainka said.

“The merits of small caps have definitely been overstated,” concedes John Rekenthaler, research chief at Morningstar. Still, he doesn’t advise investors to abandon small-stock funds as a core holding.

But investors like Goldstein have looked around for an alternative--and found it in the tech sector.

The tech sector’s weighting in the S&P; 500 index has nearly doubled in recent years, reflecting the soaring importance of technology in the revitalized U.S. economy.

“It’s too important a sector now to say, ‘I don’t understand it, it’s too risky, and therefore I’m not going to go there at all,’ ” said Colin Glinsman, manager of the New York-based Oppenheimer Quest Balanced Value fund, which has nearly a third of its equity stake in technology.

Over the last 15 years, while the typical small-company-stock fund has delivered average annual gains of roughly 11%, the average tech-stock fund has advanced about 17% a year. And over the last 35 years, tech has been among the strongest and most consistent sectors in terms of earnings growth and stock appreciation.

It’s important to note, however, that tech-stock fund managers don’t have to sell their big winners, as many small-stock managers do.

The problem with tech investing, of course, is the volatility. The typical tech fund has a beta of 1.44. That means when the stock market moves up, these funds tend to move up 44% more. But when the market drops, these funds tend to fall 44% more. By comparison, the typical small-growth-stock fund’s beta is 1.19.

This makes the tech sector a risky place to put your core assets if you’ll need to tap your portfolio relatively soon--for instance, in five years or less.

However, provided you have a considerably longer time horizon, Colorado Springs financial planner Jim Shambo says, he doesn’t object to replacing small stocks with tech stocks as core fund holdings--”provided you develop a long-term strategic philosophy--rather than a short-term tactical one--that says tech stocks will be part of your core, and stick with it come hell or high water.”

James Stack, editor of the InvesTech market newsletter in Whitefish, Mont., agrees in principle. “Under normal circumstances, yes, you can abandon small caps as part of your core,” Stack says. “And, yes, I think there’s room for technology stocks in there”--especially market leaders such as Intel or Cisco. The question is, is this the time to make such a switch?

“The problem today is that you’d be paying the steepest prices in history for alternatives to small stocks,” if the alternative is a pure tech-stock fund or a large-stock growth fund, Stack says.

What else could you substitute as a core fund holding in place of small stocks?

Some investors might opt to build up their cash holdings or bond holdings and wait for market downturns to invest more in large stocks, tech stocks or other now-high-priced sectors.

Another idea: mid-cap stocks, which in capitalization rank between the biggest stocks and the small-stock majority.

As with small caps, many mid-caps are currently trading at bargain prices relative to blue chips, using such measures as price-to-earnings ratios.

Yet over the last five years, the average mid-cap growth-stock fund has gained 16.7% a year, versus 12.1% for the average small-stock growth fund, according to Morningstar.

(The Morningstar tables elsewhere in today’s section list top-rated mid-cap funds.)

Unfortunately, as with small-stock-fund managers, mid-cap fund managers are handcuffed. The best-performing mid-cap stocks become large caps, at which point a mid-cap manager may have to sell. America Online is a recent example of a hot mid-cap stock that quickly became large-cap--and was sold by many mid-cap managers because they had to.

Some analysts also argue for beefing up core foreign stock holdings today, because many markets have underperformed the U.S. in recent years and thus may be due for a bounce.

But that same logic could be applied to small stocks, of course. One big difference: Foreign stocks don’t have a strong correlation to U.S. blue chips. In other words, while large and small U.S. stocks zig or zag in the same general direction, foreign stocks may zag when U.S. stocks zig.

Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.