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The Case For Small Caps

By Werner Renberg

One of the many theories that some Wall Street “experts” discuss each year -- but, which, of course, they cannot guarantee to be a reliable guide for investing your money -- is that stocks of companies with small capitalizations are supposed to do well in January. 

(A company’s market “cap” is derived by multiplying the price of one of its shares of stock by the total number outstanding. Definitions vary, but any cap of less than $1.5 billion, the largest cap of the 2,000 corporations making up the Russell 2000 Index, may be regarded as “small-cap.” The Russell Top 200’s caps start at $13 billion.)

This past January, the theory held up: the Russell 2000, a leading measure of small-cap stocks’ performance, beat the Russell Top 200 Index, 5.2 to 3.8 percent, and the Standard & Poor’s/BARRA 600 Small Cap Index beat the S&P 500 Index, a benchmark of the broad U.S. stock market as well as of large-cap stocks, 4.3 to 3.6 percent.

Except for January 2000, when the Russell 2000 and the S&P/BARRA 600 outperformed their large-cap siblings by going down less, the small-cap indexes had consistently lagged the others every January for the previous six years.

Is it likely that the January 2001 results established a pattern for the comparative performance of small vs. large-cap stocks for the rest of the year? Nobody knows.

What good then is this theory (or any other theory that has no predictive value)?

For at least one thing: It demonstrates the importance of maintaining a diversified portfolio of equity mutual funds -- one that includes funds invested in small- as well as large-cap stocks and growth-oriented stocks as well as so-called value stocks -- instead of trying to guess which sectors the market will favor and for how long.

For a case for being partially invested in a small-cap fund, consider the thoughts of Gregory A. McCrickard, manager of the T. Rowe Price Small-Cap Stock Fund since 1992, who chooses stocks with caps within the range of the Russell 2000’s universe.

Looking back to the recent period, he believes that small-cap stocks held up fairly well -- in 2000, his fund returned 16.5 percent while the Russell 2000 was down 3.0 percent -- because “speculative excess” had not driven them up as much as large-caps. Thus, they were less vulnerable to correction. (The Top 200 was off 12.1 percent.)

As for value vs. growth, he invests in both, explaining: “We can have lower volatility with good returns through our core value stocks and then adding growth stocks when they look inexpensive.”

He recalls that growth stocks “came crashing down to reality in 2000” after “a year of hopes and dreams” in which people would buy them just on the basis of “a great story -- it didn’t matter if (a company) didn’t have any earnings.”

He now considers both small-cap growth and value stocks to be “close to the point where both are about fairly valued” and “reasonably inexpensive” compared with the broader market.

At the end of 2000, when McCrickard’s portfolio had a price/earnings ratio of 17.6, the Russell 2000’s stocks were selling at an average p/e ratio of 22.5 and the Top 200, at 27.8.

It has to be noted, however, that large-caps’ higher p/e was not totally without justification: the Top 200 had enjoyed much higher average growth in earnings per share over the last five years, 28.2 vs. 13.1 percent -- something that McCrickard found “really hard to explain” at this point at the business cycle. That said, he now expects the earnings growth rate of large-caps to slip and that of small-caps, “which have an ability to grow earnings very rapidly” in an economic recovery, to pick up steam.

(An often-used indicator of relative valuations for small-cap stocks: the ratio of T. Rowe Price New Horizons Fund’s p/e to that of the S&P 500. At the end of 2000, it was 1.41, up from 1.03 at the end of 1999 and slightly above its long-term average, John H. Laporte, portfolio manager of the oldest small-cap growth fund, says. It was higher because of the influence of tech stocks, he explains, adding, “Most small-caps are still very cheap, with p/e’s of 10 to 15.”)

McCrickard expects value stocks’ superior performance to continue and guesses that growth stocks “are due for a pretty good snap-back some time” in 2001. “Usually, growth stocks tend to do well the first couple of quarters moving out of a recession,” he says, emphasizing that he is uncertain whether we are, or will be, in a recession. “Then as the economy picks up strength, the value stocks really power through.”

He thinks that tech stocks, a lagging sector within the small-cap universe in 2000, “are pretty good values now.” They were hit hard last year largely because of sluggishness in large-cap companies’ capital spending on information technology, he says, but “we are working our way through (that) right now.”

At the same time, because of “a bit of sector rotation,” he “probably wouldn’t be putting a lot of money to work” in energy, health care, financial services, and real estate, which he bought “a lot of” in 1999 and which did well in 2000. “I’ve had some banks that were up over 100 percent last year.”

What could go wrong with his outlook?

“If there is a more severe recession than expected,” he says. “If it turns out to be a long global recession, we have risk across all segments of the market, and there is a good chance that both large and small caps will do poorly.

Copyright © 2000 Werner Renberg. Reprinted with permission.

More articles by Werner Renberg can be found here.