My Yahoo!Small Caps, Big Hopes
Shares of little companies have fared comparatively well in this bear market. They still have some oomph left for more outperformance.
Stock Market history says that small companies beat large ones coming out of recessions and stock market corrections. If history is destined to repeat, now is the time to buy into little companies, since we have had a recession and a doozy of a correction. For some perspective, look at the wicked 1973-74 bear market. You think we have problems now with al Qaeda, Enron, the dot-coms and Martha Stewart? In the 1970s we had Watergate, OPEC, horrid inflation and stagnating productivity. Plus the implosion of the Nifty Fifty large cap growth stocks, which had fueled a speculative market much as Internet stocks did in the 1990s. As measured by the S&P 500, the early-1970s crash was easily as bad (down 48%) as the current one was at its depths in July (49%).
Now look at the sequel: From 1975 until 1983 stocks of companies with small capitalizations returned a stunning yearly average of 33%, or 14 percentage points per year better than large caps. Emerging out of the past century's six major bear markets, says Ibbotson Associates, the average one-year rebound for small caps was 82%, versus just 52% for large caps. To be sure, we don't know that we've hit bottom; when the history books are written, 2003 may be the year for that. But if you do think the market has turned, you ought to have money in small companies or funds that buy them. Our Best Buy ranking of small-cap funds (p. 114) lists those that beat their peers in cost efficiency and recent performance.
Post-slump, small has outperformed large for a couple of reasons. Small companies are more nimble, meaning they're better able to cut costs or veer off into new lines of business than the behemoths. Also, the diminutive players have greater room to grow: Blue chip McDonald's (nyse: MCD - news - people ), for example (worth $31 billion, price/earnings ratio 19), will be lucky to increase sales 5% this year, while little-known drive-in restaurant operator Sonic Corp. (nasdaq: SONC - news - people ) (worth $1.1 billion, P/E 25) has increased sales 24% over the last three quarters. Thomson First Call reports that analysts expect earnings of the small-cap S&P 600 to grow 34% next year, versus 19% for the large-cap S&P 500.
One thing that may hold back small caps during the next recovery: In this bear market, small caps (defined as issues valued at $2 billion or less) already have done well. The S&P 600 index of small companies, from the downturn's start to April 2002, rose a heady 17%; this summer's rout pulled the small-cap index back to even with March 2000, but that's better than the S&P 500's wretched showing.
Even so, there should be mileage left in the little companies. On average, a small-cap cycle lasts five years; we are barely two years into this one. The shortest was three years (1990-93); the longest, eight years (the 1975-83 one). Because large caps were last ascendant for a long time (from 1994 through 1999), says Satya Pradhuman, the chief small-stock strategist at Merrill Lynch, a small-cap era lasting for another three years is plausible.
Also, small stocks are still attractively cheap by historical standards. The Leuthold Group estimates they are trading at a 35% discount (in price/earnings) to large ones, compared with a historical average discount of 15%.
Let's make a further refinement in the small-company universe: Divide it into value companies and growth companies. Since March 2000, according to Lipper, small-cap value funds have clocked an annual 8% gain while small-cap growth, enamored of tech, lost 26%. Other than gold funds, the best equity performers over the last three years have been small-cap value funds. That doesn't necessarily mean that now is growth's turn. Value just pays better over long periods: 15% a year over the past two decades, among small companies, to 10% for growth.
One reason to prefer the small-value funds over small-growth: slower turnover of their portfolios (72% a year for value, says Morningstar, to 131% for growth). So if you are going to own both a small-growth fund and a small-value fund, put the growth fund in a tax-sheltered account where the capital gain dividends will cause no pain.
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