Small- and mid-cap stock funds lead the way

Smaller stocks far outraced their blue-chip brethren in the last decade. Now, they're sprinting well ahead once again, defying predictions that big-name shares would take the lead in market performance.

Mutual funds that own stocks of so-called small-cap and mid-cap companies racked up gains of 6.9% to 9.4%, on average, in the three months that ended March 31, according to fund tracker Lipper Inc.

By contrast, large-cap stock funds posted first-quarter total returns averaging less than 6%.

The story was much the same in 2010, when small-cap and mid-cap funds generated gains of 20% or better versus returns in the mid-teens for large-cap funds. A fund's total return includes the change in its share price plus any dividends it pays.

In part, the continuing performance streak of smaller stocks reflects Wall Street's growing sense that the U.S. economy is unlikely to fall off a cliff again. When investors conclude the economy will keep improving, they naturally become willing to bet on riskier enterprises, including smaller firms.

"Small companies tend to be more focused and less diversified than bigger ones. This can be fatal during recessions but may be a big positive during expansions," said Edward Yardeni, head of Yardeni Research Inc. in New York.

Don Wordell, manager of the RidgeWorth Mid-Cap Value Equity fund in Orlando, Fla., notes that the U.S. financial system has healed further over the last year and that private-sector job growth finally has begun to pick up.

"When I look at the overall environment, I am more encouraged" about the economy, he said.

Still, many market pros had expected investors to shift their focus to blue-chip shares this year. One argument in favor of big-name multinational stocks was that their global reach offered better potential growth prospects in 2011 than those of many smaller, niche companies.

Another argument was simply that large-cap stocks had become bargains relative to earnings as many investors ignored them and chose other places for their money in 2010 — not just smaller stocks, but also commodities and corporate bonds.

Classic "value" investors such as Jeremy Grantham, co-founder of money manager Grantham, Mayo, Van Otterloo & Co. in Boston, were making the case for big stocks over other ideas early this year. In a letter to clients in January, Grantham described the highest-quality blue-chips as "very cheap."

By one common yardstick, blue-chips appear compelling: The average price-to-earnings ratio of the Standard & Poor's 500 index of big-company stocks is 13.7 based on estimated 2011 operating earnings per share, according to S&P.

By comparison, the P/E ratio is 19.0 for the S&P index of 600 small-cap stocks and 18.3 for the S&P mid-cap 400-stock index.

Still, the momentum has stayed with small- and mid-cap stocks. The S&P small-cap index gained 3% in March and the mid-cap index rose 2.4%, while the S&P 500 was largely unchanged.

Satya Pradhuman, who tracks small stocks as head of Cirrus Research in Tarrytown, N.Y., said one explanation for investors' robust appetite for the companies is the expectation that bank lending conditions will continue to ease. Access to credit is key to many smaller companies' success, he said.

As credit conditions improve, "you see the top line accelerate for small-cap companies," Pradhuman said. "That's what extends the cycle [for the stocks' performance] longer than people think."

Some market players cite another force driving the stocks: They say smaller issues are favorite targets of hedge funds and other investors with relatively short-term time horizons and a desire to get more bang for their equity buck. After all, it takes less money to drive up a small-cap stock than shares of Wal-Mart Stores or Cisco Systems.

Generally, a small-cap company is one whose market capitalization (stock price multiplied by the number of shares outstanding) is less than $2 billion, and a mid-cap company is one with a market cap of between $2 billion and $10 billion. Large caps are the minority — firms whose shares are worth $10 billion or more.

But just as speculators can quickly drive up smaller stocks, they also could quickly drive them down by bailing out if sentiment about the economy should turn bleak.

For investors who worry that the smallest stocks may be too frothy after their latest run-up but who also see blue-chips as too stodgy, mid-size stocks may be a good compromise.

The mid-cap sector has gained a reputation as the market's "sweet spot" over the last decade or so. In the 15 years that ended March 31, the S&P mid-cap index produced a total return of 419%, compared with 302% for the S&P small-cap index and 168% for the S&P 500.

Proponents of the mid-cap sector say the companies tend to be more seasoned than smaller firms and more financially stable, yet aren't handicapped by size as some blue-chips are.

Mid-caps have "perennially been a really good risk-adjusted place to be," said Kim Scott, manager of the Waddell & Reed Advisors New Concepts stock fund based in Overland Park, Kan.

The fund, which focuses on mid-cap issues, rose 8.4% in the first quarter and was up 8.8% a year over the last five years, beating 96% of its peers, according to Bloomberg data.

Investors may underestimate the dynamism of management at many mid-cap firms, Scott said. "It's remarkable how well-run the companies are," she said.

Her portfolio includes auto-parts maker BorgWarner Inc., which she said was "a fabulous combination of industry and technology." The company is a leading maker of turbochargers that improve car engine power and efficiency.

Scott also owns shares of retailer Williams-Sonoma Inc., which she said has masterfully used its stores as showrooms while expanding its online sales. That has allowed the company to reduce store inventories, boosting cash flow.

Wordell, at the RidgeWorth Mid-Cap Value fund, is a fan of banks including Chicago-based MB Financial and BB&T Corp. of Winston-Salem, N.C.

"Credit is clearly getting better, and we're starting to see loan growth again," Wordell said.

His fund, which rose 7.3% in the first quarter and gained 8.3% a year, on average, over the last five years, also owned industrial lubricants maker Lubrizol Corp. — which last month accepted a $9-billion takeover offer from Warren Buffett's Berkshire Hathaway Inc.

Wordell says the deal points up another draw of mid-cap companies: their appeal to cash-rich larger firms hungry for new growth opportunities.

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