Small-company funds seeing bullish numbers

MUTUAL FUNDS

November 28, 1993|By Werner Renberg

When you buy shares of a well-managed, diversified equity mutual fund, you may hope to enjoy long-term performance exceeding that of the broad stock market, as measured by Standard & Poor's 500 Index.

When you buy shares of an equity fund that is invested primarily in small companies' stocks, you do so because history tells you that it could fare a lot better than the large-company-dominated S&P 500 over the long run.

But when you're in such a fund and the market for small-company stocks becomes turbulent, as it was again recently, should you be concerned? If you've been thinking about one, should you forget it?

Not really -- provided that you have a long investment horizon, enabling you to benefit from the above-average earnings-growth rates that should boost small companies' stock prices, and provided that you own, or are considering, a fund whose manager excels at stock selection.

Recognize that small-company stocks are more volatile than large-company stocks -- in part because they pay no or low dividends -- and, assuming that you can accept the volatility, derive some reassurance by understanding their relatively predictable, cyclical behavior.

Two characteristics stand out and give you something to lean on:

* Small-company stocks have tended to lead and lag large-company stocks for alternate periods of several years (during which interim drops and surges add a -- of spice to your life).

* When the average price/earnings (P/E) ratio of a diversified small-company stock fund's portfolio is much higher than the 500's P/E ratio, the risk is high that small companies' stocks will lag. When the small-company fund's P/E ratio is even with or little higher than the 500s, it should lead; investors usually agree to pay a higher P/E for stocks of small companies with fast-growing earnings.

Noting that relative performance cycles have averaged about five years and that this cycle of small companies' outperformance began in October 1990, portfolio manager John H. Laporte of T. Rowe Price New Horizons Fund says he thinks it has at least two more years to go.

He cites relative P/E ratios to support the case. New Horizons is selling at 20.9 times Price estimates of the next 12 months' operating earnings for the 260 companies in its portfolio vs. a P/E ratio of 16.7 for the S&P 500. Thus, the ratio of the fund's stocks to the 500's is 1.25 -- at the low end of the historical 1.0-2.0 range.

Scudder's similar work, using actual total earnings that reflec write-offs, leads to a similar conclusion. Scudder Development Fund sells at 1.1 times the 500's P/E ratio vs. a 1.2-1.8 "normal" range.

Will relative ratios reach the tops of the ranges before this cycle ends? Maybe not, Laporte says, but he does see it continuing at least until his fund hits 1.5. For one thing, demand for small-company stocks, which are bought for appreciation, should be enhanced by the greater spread between capital gains and ordinary income-tax rates, he adds.

Beneath the dry, if encouraging, ratios, of course, are real companies that have been raising their earnings 25 percent or more a year and have succeeded in being spotted by managers of leading funds. Despite slow economic growth, they say, they continue to find such companies.

Michael P. DiCarlo, portfolio manager of John Hancock Special Equities Fund, which led small-company growth funds over the past five years, with an average annual return of 28 percent, attributes his recent record largely to technology and consumer cyclical stocks.

He pursued the technology theme, he says, because he saw opportunities to profit from companies that provide equipment and services that help customers improve their productivity.

His heavy investment in consumer issues, like media, specialty retailing, and apparel, was not planned, however. "I wasn't really looking in this area," he said. "I just kept finding good values."

Because DiCarlo didn't want the portfolio to exceed 60-65 stocks, Hancock closed the fund to new investors in September.

To David Alger, portfolio manager of Alger Small Capitalization Portfolio, the recent drop in P/E ratios of stocks with 40 percent yearly earnings increases is "a prelude to explosive growth."

His best performers have been fast-food, cellular-telephone and technology stocks, he says. He missed the rise in financial services, Alger explains, because they're "really not our area;" he focuses on companies with fast growth in unit sales.

Roland Gillis, who manages Keystone S-4 Small Company Growth Fund, says he has used recent price drops to buy more of companies that he liked and to buy back stocks on which he had taken profits.

He has found attractive issues in data storage, specialty retailing, biotechnology, gaming and oil services.

you study literature for these and other small-company growth funds to judge which may be most suitable for you, you'll see funds using the Russell 2000 Index (whose performance Vanguard's Small Capitalization Stock Fund tracks) as the most appropriate benchmark.

If a fund has performed better or worse than the index, it could be due to a difference in their sector mixes (and the fund's cash reserves).

Russell's three largest sectors are consumer discretionary, 18.8 percent of its market capitalization; financial services, 18.5; and health, 13.8.

Another possible difference: capitalization (stock prices times number of shares). With its companies' "caps" ranging from $3 billion to $20 million, the index is more inclusive than leading funds that tend to invest only in companies with "caps" under $1 billion, if that high.

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