Investors Eye Big Returns From Smaller Stocks


Didn’t smaller companies get the memo about the economic slowdown?

Wall Street’s earnings growth expectations for this year remain far rosier for small and mid-size companies than for blue-chip firms, data show. Those expectations appear to be helping small and mid-size stocks hold up much better than big stocks.

The average company in the Standard & Poor’s small-cap 600 index and in the S&P; mid-cap 400 index is expected to post earnings growth of 21% this year, according to analysts’ earnings estimates as tracked by First Call/Thomson Financial.

By contrast, earnings of the average blue-chip company in the S&P; 500 are expected to rise just 5% this year, First Call data show.


Investors seem to be taking the numbers to heart: So far this year, the S&P; 600 index is up 1.3% and the S&P; 400 is off 1.2%, while the S&P; 500 has sunk 4%.

But even fans of small and mid-size stocks say the aggregate earnings gains estimated for those companies may be overly optimistic, thanks to some of the peculiarities of those sectors.

Steven DeSanctis, an analyst who follows smaller stocks at Prudential Securities in New York, said though many companies in that universe so far are faring better than big companies amid a weaker economy, he doubts the average smaller firm will manage to post 21% earnings growth this year.

Because smaller companies usually are followed by fewer analysts, the “consensus” estimate figures that become a company’s de facto growth target can be skewed by one or two bullish projections, DeSanctis said.

In addition, energy companies tend to hold a bigger weighting in smaller-company indexes than they do in the S&P; 500, he noted. Energy companies’ earnings have been robust recently, of course--that’s the upside of an energy crisis.

DeSanctis also said he has found that smaller-stock analysts often are simply more optimistic than analysts who follow blue chips.


Still, with the troubles faced by many multinational giants over the last few years--from Coca-Cola to Lucent Technologies to Xerox--more investors may be appreciating smaller companies in easier-to-understand businesses, analysts say.

Many of those stocks were ignored from 1995 through 1999, as blue chips soared. That changed last year, when the S&P; 600 index rose 11% and the S&P; 400 gained 17.5%, while the S&P; 500 fell 9.1%.

Even if 2001 earnings estimates for smaller companies overall are too optimistic, experts point out that the recent strength in smaller firms’ earnings goes well beyond the energy sector.

Home builders such as D.R. Horton (ticker symbol: DHI) and Toll Bros. (TOL) and a variety of specialty retailers such as shoe maker Skechers USA (SKX) are among the small to medium-size companies that have been “blowing away” earnings estimates and guiding forecasts higher, DeSanctis said.

Manhattan Beach-based Skechers, whose brand of casual urban shoes has gained marketplace traction as the firm has rolled out new stores, saw its stock jump a combined 36% in two days last week after announcing fourth-quarter net operating profit of 26 cents a share, versus 8 cents a year earlier.

The company, whose stock was up 97% in 2001 through last week, is expected to earn $1.68 a share this year and $2.05 in 2002, according to earnings tracker IBES/ Thomson Financial. At $28.50 a share on the New York Stock Exchange on Monday, the stock is priced at 17 times this year’s estimated earnings--compared with a price-to-earnings ratio of 22 for the average blue-chip stock.


Art Bonnel, who manages the mid-cap-stock Bonnel Growth fund, said he recently has bought stocks across a variety of industries, including chip components producer All-American Semi (SEMI); Woodward Governor (WGOV), which makes fuel-delivery systems and other engine products; brokerage Raymond James Financial (RJF); home builders Standard Pacific (SPF) and Ryland Group (RYL); discount chain Family Dollar Stores (FDO); and youth-oriented apparel sellers Gadzooks (GADZ) and Quiksilver (ZQK).

“A lot of individual investors are looking more at these sorts of companies with decent earnings numbers and reasonable valuations,” he said.

The companies Bonnel likes generally sport modest P/E multiples, and their earnings growth expectations are respectable but not spectacular, he said.

Analysts, for example, expect Woodward Governor to earn $3.75 a share in the fiscal year ending this September and $4.25 the following year, for 13% growth; Standard Pacific to earn $3.69 a share in 2001 and $4.08 next year, for 11% growth; and Quiksilver to make $1.56 a share in the fiscal year ending this October and $1.82 next year, a 17% estimated rise.

Andrew Parnes, chief financial officer at Irvine-based Standard Pacific, said his company has gained market share through new housing projects in Western states and entry into niche markets such as its first “active adult,” or age-restricted, community, which is set to open later this year.

The firm’s January housing orders “held up nicely” compared with a year earlier, he said. The stock is up nearly 8% this year.


Dan Sullivan, editor of the Seal Beach-based investment newsletter The Chartist, noted in a recent commentary that numerous small-cap stock rallies have fizzled in recent years, including one in early 2000. But those were narrow, focused mainly on technology and biotech stocks, and driven more by speculation than by fundamentals, he said.

This time, smaller stocks’ rally is far broader, which could be a healthy sign, he said.

Analysts note that cycles of small-stock dominance, such as the one that ran from the mid-1970s through the early ‘80s, can last for years when they get going.

And they note that over very long stretches, such as 1970-98, smaller stocks have tended to outperform blue chips. (A basic theory is that smaller stocks are riskier, and that the stock market rewards risk-taking in the long haul.) So a return to small-cap leadership would, in a sense, be a return to the norm for a market that had gotten out of whack in recent years.

Of course, if the U.S. economy falls into recession, all bets--on stocks of any size--may be off, analysts warn.

“With big companies like Sun Microsystems [SUNW] seeing slowdowns in their business, eventually that works its way down the food chain,” DeSanctis said. “The smaller companies are not going to be immune.”

Still, some analysts argue that the relatively low P/E ratios on many smaller stocks make the shares appealing, especially for investors who have painfully rediscovered the risks involved in former high-flying large growth stocks in technology and other sectors.


“The value gap in the small-cap space remains compelling,” Merrill Lynch & Co. analyst Satya Pradhuman wrote in a report last month. “The risk of a severe economic slowdown appears to have been priced into the smaller-cap market.”


Josh Friedman can be reached at

Smaller Stocks, Bigger Earnings?


Smaller Stocks, Bigger Earnings?

Earnings growth for companies in both the Standard & Poor’s 600 small-company index and the S&P; 400 mid-size-company index is expected to be much stronger this year than earnings growth for the blue-chip companies in the S&P; 500. Here’s a look at analysts’ average profit growth estimates for various industry sectors within the S&P; 600 and S&P; 400 and for the indexes overall, comparing the first quarter of 2001 with the first quarter of 2000 and comparing 2001 overall with 2000.




Est. EPS* Est. EPS* Number growth, growth, of Industry sector Q1 2001 2001 companies Consumer staples +234% +59% 27 Energy +9 +37 47 Financials +18 +25 59 Consumer cyclicals -2 +16 143 Health care 0 +15 120 Technology +8 +14 118 Communications -14 +11 25 Utilities +15 +9 24 Basic materials -34 +5 34 Capital goods NA -87 3 S&P; 600 index total +13 +21 600




Est. EPS* Est. EPS* Number growth, growth, of Industry sector Q1 2001 2001 companies Communications NA +112% 4 Capital goods +2% +26 37 Transports -2 +25 13 Basic materials -37 +24 31 Financials +4 +22 50 Technology +9 +22 73 Consumer cyclicals -10 +21 66 Consumer staples +3 +19 41 Energy +142 +19 20 Health care +3 +15 33 Utilities +12 +15 32 S&P; 400 index total +13 +21 400 S&P; 500 index total -3 +5 500


* Earnings per share

NA = not available

Source: First Call / Thomson Financial