What's behind recent surge in shares of smaller firms

The Insider

Your Money

December 05, 2004|By BILL BARNHART

IT'S A SMALL world, again, on Wall Street.

Defying conventional wisdom, small-company stocks are beating large-cap stocks in 2004 after a torrid 2003.

The latest leg of the small-cap rally, beginning Aug. 12, resembles the speculative fever that bewildered analysts last fall.

"You had quality [stocks] doing better in the first half of the year. People want to take risks at this time of year," said Steven J. DeSanctis, small-cap research chief at Prudential Equity.

The Russell 2000 small-company index is up 24 percent from its August low, double the gain by the Standard & Poor's 500 large-cap index.

Small caps with no profits are up 29 percent, DeSanctis said.

Market historians point to the January effect - the persistent tendency of small-cap stocks to outperform big caps in January. Buying in anticipation of that seasonal event explains part of the year-end small-cap gains.

Here are some drivers of the small-cap rally that you probably have not heard of. They will determine whether the January effect will linger:

Sarbanes-Oxley

Small public companies are wrestling for the first time to certify their internal financial controls under the Sarbanes-Oxley corporate reform law.

The costs and headaches of compliance prompted many small firms to seek a buyer, said Linn J. Arbogast, small-cap manager at Segall Bryant & Hamill.

But auditors of would-be buyers "are telling them, `Do not do anything to your financial systems, because we can't certify your financials.' That's pushed the acquisition binge into next year," Arbogast said.

Dividends

This year, more of the small-cap stocks leading the rally pay dividends - a payoff small-cap investors are beginning to demand.

Michael A. Crowe, who manages small-cap equities at Mesirow Financial, said dividend income in his portfolio was up 17 percent in the third quarter over the same period last year.

Lower global exposure

Small-cap companies are developing markets overseas, enabling them to benefit from the weaker dollar. But they tend to sell in niche markets that are less vulnerable to global trends.

On the other hand, many U.S. small caps are less exposed to the risks of global economies and currencies.

U.S economic growth should slow next year but still beat many of its trading partners, where the entrepreneurial spirit is less developed.

"We're just not that dependent on them," said Randall S. Kroszner, an economics professor at the University of Chicago Business School. "We're just not that open an economy."

Hedge fund pressure

Private investment partnerships, called hedge funds, have added a new and perhaps scary element of liquidity to small-cap trading.

Many hedge funds engaged in rapid-fire trading, contrary to the traditional buy-and-hold small-cap investor.

"Hedge funds are naturally attracted to small caps," said John Rowsell, president of Glenwood Capital Investments, a unit of Man Group PLC. "It's very hard to get an edge in something like General Electric."

Bill Barnhart is a columnist for the Chicago Tribune, a Tribune Publishing newspaper. E-mail him at yourmoney@tribune.com.

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