Now may be good time to join small company stock funds

MUTUAL FUNDS

January 10, 1993|By WERNER RENBERG

Many of those who market small company stock funds take it on faith that, since seven fat years from fall 1976 to summer 1983 were followed by seven lean years, we're now in another fat period for small company stocks that has four or five years to go.

They would also have you believe that the behavior of small company stocks is predictably cyclical -- in that they alternatively lead and lag large company stocks -- even if it's not quite guaranteed.

Therefore, they reason, you would want to add one of their funds to your portfolio now -- despite the strong performance that a number of them have enjoyed since October 1990.

To be fair, of course, it must be said that those who still recommend small company stock funds do so for additional reasons:

* Small company stocks currently represent better values than large company stocks, as reflected by Standard & Poor's 500 Index.

* Small company stocks have beaten large company stocks both over the very long run and in periods of recovery from recession.

* Small companies, some say, will fare better under President-elect Bill Clinton.

So, should you think about investing some of your money in one of them?

To answer that, you've got to address at least three questions:

1. Whether any equity fund is appropriate for you, given your investment goals and financial circumstances.

2. Whether you are able and willing to accept the above-average volatility that's characteristic of many small company stock funds.

3. Whether you require income. (Small companies pay low dividends, if any.)

If you've satisfied yourself on all counts, but wonder whether you're too late, you may find some assurance in the valuation case.

Perhaps the simplest version is based on data calculated by T. Rowe Price Associates for the portfolio of its New Horizons Fund -- at 32 years, the oldest of 150 small company growth funds tracked by Lipper Analytical Services -- and often cited by competitors.

Portfolio manager John H. Laporte and his team regularly estimate earnings for the coming 12 months for the 200 companies whose stocks the fund holds to determine the portfolio's average price-earnings (P/E) ratio. They next compute P/E ratio for the S&P 500, based on their estimates of the 500 companies' earnings. And, finally, they figure the ratio of the fund's P/E ratio to that of the index.

Since New Horizons' inception, small company stocks have become vulnerable when the ratio reached 2.0 but have been relatively good values when the ratio bottomed around 1.0. At the end of 1992, following the fourth-quarter surge by small company stocks, the ratio was still only 1.2, according to Mr. Laporte's preliminary estimate.

So what do you buy? While Wilshire's Small Value Stock Index outperformed its Small Growth Stock Index last year, 29.2 vs. 13.2 percent, and led over longer periods by smaller margins, you may find an attractive prospect among either value- or growth-oriented funds.

Among those concentrated in growth stocks, the Kaufmann Fund stands out, having been not only the top small company growth fund of the last five years -- with an average return of 34.2 percent -- but also No. 1 among all equity funds, according to Lipper.

Co-manager Lawrence Auriana says he looks for companies whose earnings are likely to increase annually by at least 25 percent over the next three years. They should be companies that are early in their growth cycles, have above-average returns on shareholders' equity and generate sufficient cash to finance their capital requirements.

& 1993 By WERNER RENBERG

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