Is It Time to Think Small Caps? Maybe Next Year
Small-company stocks have withstood the bear market of the last year and a half far better than shares of larger companies.
But big-company stocks have proved more resilient in the weeks since the Sept. 11 terrorist attacks rocked U.S. securities markets, casting doubt on which group will prove the better bet for investors.
On the one hand, small-company stocks--referred to as small caps because of their smaller market capitalization--have fared best coming out of recessions. With the U.S. economy widely thought to be slipping into recession, that could bode well for these issues. Also, by some measures they are still relatively cheap compared with shares of large-and mid-cap companies.
But the anemic U.S. economy could work in favor of large-company stocks--at least in the near term--because they are perceived as being less volatile investments, analysts and even some small-stock fund managers said.
“You hear a lot of talk about how small caps typically lead the way out of recession,” said Warren Isabelle, manager of the ICM/Isabelle Small Cap Value Fund. “The problem is, are we turning around economically or going down deeper? After Sept. 11, it appears we are going down steeper and faster.”
However, if the economy perks up in 2002, as some analysts expect, smaller stocks could set the pace again, including the slumping small-cap growth sector.
Over the last year, while the large-cap Standard & Poor’s 500 index has tumbled 22.9% and the S&P; mid-cap 400 index has dropped 12.4%, the S&P; small-cap 600 index has given up only 5.6%.
But in the wake of the Sept. 11 terrorist attacks, the S&P; 500 has held up better than the smaller indexes with a loss of 0.5%, compared with a loss of 1.6% for mid-cap stocks and a loss of 2.1% for small caps.
Isabelle called the broad rally since the market hit its recent lows Sept. 21 “basically a sigh of relief that we’re not plummeting into an abyss after Sept. 11, rather than a clear indication that we have turned the corner.” Layoffs that occurred before Sept. 11, for example, have yet to work their way through the economy, he said, let alone post-attack layoffs.
And although small-cap stocks generally look cheaper than blue chips based on yardsticks such as price-to-earnings ratios, Isabelle said, their ability to flourish in the current economic situation is another matter.
“The problem with the small-cap argument is simple: cash flow fundamentals,” he said. “Smaller companies have less of a cushion in difficult times.”
Large firms tend to have steadier earnings and more diversified businesses, making them less vulnerable in a tough economy.
Indeed, combined profits for S&P; 500 firms are expected to fall 21.8% in the third quarter and 16.3% in the fourth, according to Thomson Financial/First Call. But the S&P; small-cap 600 is expected to fare worse, with earnings declines of 30.2% in the third quarter and 22.5% in the fourth.
The valuation argument, meanwhile, can be used against--as well as for--small caps.
According to First Call, the S&P; 500 trades at a price-to-earnings ratio of 23.5 based on 2001 earnings estimates, compared with a ratio of 20.8 for the S&P; small-cap 600. Other things being equal, the lower a stock’s or index’s ratio, the better the bargain.
But small-cap stocks aren’t as cheap as they were 18 months ago, thanks to their stronger performance relative to large-company stocks, said Stuart Freeman, chief equity strategist at brokerage A.G. Edwards in St. Louis.
Still, argued Satya Pradhuman, small-cap research director at Merrill Lynch & Co., “the adage that large is safe may not hold up this time around. If, as investors become more conservative, they pay more attention to stock valuations relative to earnings and cash flow, that still tends to help the small-cap end of the spectrum.”
The near term for smaller stocks may look questionable, but the anticipated economic rebound in 2002 could give them a big lift, some analysts said.
During the last three recessions, in 1980, 1982 and 1990, the S&P; 500 was up an average of 33% a year after bottoming, said Sam Stovall, senior investment strategist at Standard & Poor’s. But the Russell 2,000 index, another proxy for smaller stocks, rose an average of 66% during those post-recession years, and the Nasdaq composite index, which is heavy in tech stocks, surged 67%.
One reason small firms do well coming out of recessions, said Brad Lawson, senior research analyst at Frank Russell Co. in Tacoma, Wash., is that their businesses are tightly focused on the U.S. economy, with little international exposure. “So when things get good [for the U.S. economy], they get really good for small caps.”
Will Muggia, manager of the Touchstone Emerging Growth fund, said he thinks large caps “may lead the market over the next couple of months ... but looking out 12 to 18 months, small caps can retake the lead.”
Muggia said he is positioning his portfolio for growth in 2002.
Small-cap “value” stocks--shares thought to be beaten down to bargain prices--have outperformed pricier growth-oriented stocks over the last 20 months, he said. “But once the consumer gets confident again, small-cap growth is going to be like a coiled spring.”
While investors are “fixated on today’s headlines,” companies are busy “throwing in all their bad news,” he said.
“Brokerage analysts are setting their [earnings] forecasts even below company guidance. They’re shellshocked. The bar is low and everything is in place for stocks to do better than people expect next year, with small-cap setting the pace.”
Muggia said he has been adding technology and consumer cyclical stocks while trimming energy and financial holdings.
Isabelle, meanwhile, said he has been finding value in mundane sectors such as basic industries, “the metal benders and chemical makers, companies that make the stuff that help people make stuff.”
Stocks he likes include Commonwealth Industries Inc., Graphics Packaging International Corp. and PolyOne Corp.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Plunging Profits
Small companies are expected to suffer the biggest profit declines in the third and fourth quarters, according to Wall Street analysts. But they’re expected to see the biggest increases next year.
*--*
Estimated change in earnings per share Period S&P; 500 S&P; mid-cap 400 S&P; small-cap 600 3Q ’01 --21.8% --16.6% --30.2% 4Q ’01 --16.3 --15.4 --22.5 2001 (full year) --15.3 --9.3 --16.7 2002 (full year) +15.5 +15.5 +24.0
*--*
Source: Thomson Financial/First Call
