Small caps suddenly looking to fly again Beaten-down funds may offer value

Mutual funds

November 15, 1998|By Jerry Morgan | Jerry Morgan,NEWSDAY

Like a rocket ship beginning to lift on its tail of fire, the small-capitalization market looks ready to blast off. The only question is whether it will fly into orbit or fizzle and splash down.

The numbers suggest that we may be in for a small-cap boom that will last a while. The quantitative indicators that technical analysts see are the relative valuations of small-cap stocks to large-cap stocks. And they are lower. When that happened in 1979 and again in 1990, it started more than three years of small-company dominance over large-cap stocks each time.

If it happens now, it will come off a dismal year for small-company stocks, which have been hugely overshadowed by the large-growth stocks and indexes for the past three years.

"This is not surprising because the stocks have been beaten down for the last couple of years," said Dave Borger, research director for Wilshire Asset Management in Santa Monica, Calif., which publishes the Wilshire 5000 stock index. "There is nothing to scare you away [from small-caps] on a valuation basis," he said. Still, Borger cautioned, "this is not a [market] timing tool."

"The valuations were the lowest since we started keeping records in 1979," said Paul Greenwood, senior research analyst at Frank Russell Co. in Tacoma, Wash. "It hit the low Oct. 8."

Before Oct. 15, when the Federal Reserve Board cut interest rates for the second time in a month, the Russell 2000 index, the prime industry measure of small-company stocks, was off 33 percent for the year. Since then, the index has jumped 22 percent.

Assets of small-company stocks fell more than 21 percent, from $137 billion July 31 to $108 billion by Sept. 17, reports Lipper Analytical Services Inc. of Summit, N.J. The decline was caused by a combination of falling stock values and redemptions from mutual funds. But by the end of October, assets had risen to $116 billion.

Performance had also been terrible until the turnaround. On Oct. 8, Lipper reported the small-cap fund category was down more than 29 percent for the year. Three weeks later, it was down only 14 percent, and rising.

The summer was particularly hard on small-company stocks. Large-company stocks fell because the Asian crisis and the Russian financial debacle were expected to hurt them. But small stocks took a dive as investors feared that if large-cap stocks were hurt, the bottom could fall out of small-caps.

"I think there was a lot of panicking, and people wanted to be in something liquid," Borger said. That led to the general flight to quality and safety, which meant Treasury securities and the stocks that make up the top of the Standard & Poor's 500 index.

"We are still off, but it has been a tremendous bounce from a negative year," said Brian Stack, manager of the Boston-based MFS Emerging Discovery Fund and its institutional small-company fund.

During the 1990 recession, the same signals led to three years in which small-cap stock outperformed large-caps. Similar signals in 1979 pointed to a small-company surge that lasted until 1983.

"The valuations are the lowest in decades," Russell's Greenwood said, "and they are poised to perform well, but the caveat is that the fundamentals have to be there."

A few factors might help. Greenwood and others said small-cap fund managers did a lot of tax-loss selling this year, which drove prices down, so there's the potential for a large bounce if earnings are there.

Hilary Woods, co-manager of Dreyfus Corp.'s New Leaders and Emerging Leaders small-company funds, pointed out during the company's recent year-end outlook meeting that the demand for initial public offerings collapsed as the market swooned.

As a result, existing small-company stocks, which might face competition from exciting IPOs, don't have to worry about them for the moment.

Small-cap stock funds generally invest in companies whose market capitalization is under $1 billion.

Pub Date: 11/15/98

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