Small Firms Are Huge in Wall Street’s Advance
John Buckingham owns a lot of stocks that other investors suddenly want.
As manager of the Al Frank mutual fund in Laguna Beach, Buckingham focuses on shares of smaller firms, and in this year’s sizzling market those stocks are the hottest of all.
Small-stock funds posted greater gains in the second quarter and in the first half than their mid-size and big-stock brethren, on average, according to fund tracker Morningstar Inc. in Chicago.
A popular index of smaller shares, the Russell 2,000, is up 21.6% this year. That far exceeds the 14.2% advance of the blue-chip Standard & Poor’s 500 index.
No one can say for sure that this is the start of a bull market, but if it is, smaller stocks are following historical precedent: They usually lead the way when the market is turning decisively.
That could be crucial for smaller companies in California and nationwide, because rising stock prices can bolster the companies’ finances and make it easier for them to raise capital for expansion.
The Russell index’s advance has been led by its technology shares, just as tech has paced Wall Street’s rally overall.
But stocks of small companies in other industries also have been rising briskly. An index tracking consumer-related shares in the Russell index is up 22.6% this year; health-care stocks in the index are up 35.2%.
Small-stock fans say the gains show investors are rediscovering the growth potential in smaller companies, particularly as hopes rise that the economy will pick up speed in the second half.
“Smaller companies are more limber, so they are able to take advantage of an improving economy,” said Buckingham, whose $58-million fund climbed 24.8% in the first half of the year.
His portfolio has benefited from such shares as semiconductor component maker Diodes Inc., which is up 127% this year, to $21.85 on Nasdaq on Monday, and Web advertising firm ValueClick Inc., which is up 142%, to $6.74 on Nasdaq. Both are based in Westlake Village.
Buckingham sees similarities to the early 1990s, when smaller stocks paced the market from 1991 through 1993 even as economists fretted about high unemployment and other issues.
Tom Barry, whose Bjurman, Barry Micro-Cap Growth fund in Los Angeles rose 24.4% in the first half, also believes that small companies can continue to lead the market. “They can move faster, cut to the bone, add personnel, refocus the business,” Barry said. “They’re more nimble, like a B-29 taking on a jet airplane in a dogfight.”
Some analysts, however, worry that investors already have pushed stocks of many small companies to levels that are excessive relative to the firms’ earnings prospects. That’s an issue dogging the broader market as well.
A few years ago, “small-cap stocks looked cheap across the board,” said Russ Kinnel, director of fund analysis at Morningstar. “Not anymore.”
He noted that although many investors may be newly attracted to smaller shares, the stocks in general held up better than many blue-chip names during much of the bear market.
The Russell 2,000 index beat the Standard & Poor’s 500 index from 2000 through 2002.
“It seems a little tough to say that the small-cap leadership will continue, since they’ve had a pretty strong run already,” Kinnel said. “I wouldn’t bet big either way.”
Small-cap fund managers, however, say they still see good value in many lesser-known stocks. Barry said his portfolio’s holdings have a median price-to-earnings ratio, or share price divided by per-share profit for the last 12 months, of 26, which he called low relative to their median earnings growth rate of 85% over the prior year.
“If they can grow at that rate in a lousy economy, they might be able to continue doing it,” Barry said, “but even if they grow 50% they’re undervalued.”
Chris Ainley, co-manager of the TCW Galileo Small-Cap Growth fund in Los Angeles, which rose 21.7% in the first half, said many technology stocks that were grossly overvalued during the bull market got undervalued in the downturn.
One of his holdings is Internet search firm Ask Jeeves Inc. of Emeryville, Calif. The stock soared $2.21 to $16.40 on Monday on Nasdaq, the highest price since 2000. It’s up 541% this year.
Wall Street analysts expect Ask Jeeves to earn 28 cents a share in 2003 after losing money in its first four years. That gives the stock a P/E ratio of about 58. But Ainley says that’s reasonable based on the company’s long-term growth prospects.
He said he also expects solid profit growth from companies such as San Diego-based Gen-Probe Inc., which climbed $2.07 on Monday to a 52-week high of $45.71 on Nasdaq. The company, which makes blood screening devices, is expected to earn $1.10 a share this year, compared with 58 cents last year.
The Frank fund’s Buckingham said he still finds value in Irvine-based home builder Standard Pacific Corp., which is up 42% year-to-date. The stock is priced at eight times its trailing 12-month earnings per share, but Buckingham believes the company can continue to grow profit 15% to 20% a year over the next several years.
“When people tell me there’s a housing bubble I ask them if they’ve sold their house and moved into an apartment,” Buckingham said. “The answer is always no, and then I ask them, ‘Why not?’ ”
Standard Pacific rose 95 cents on Monday to close at $35.20 on the New York Stock Exchange.
Naturally, many Wall Street veterans are far less sanguine than small-stock money managers these days.
Billionaire Warren Buffett, for one, has cautioned U.S. investors to expect single-digit stock returns in the next few years.
But Buckingham says that’s just a matter of the “Oracle of Omaha” -- whose holding company, Berkshire Hathaway Inc., is known for sticking with blue-chip names -- being in the wrong place.
“He may only get 6% to 7% a year, but that’s because he can’t buy smaller stocks,” Buckingham said. “Those of us who can are going to do better than that.”
