Dominating run might not be over for stocks of small-cap companies

End of typical cycle near, but some argue reviving economy will add to gains

Your Money

July 31, 2005|By Andrew Leckey

This could be a monster year for small-company stocks.

Take, for example, Hansen Natural Corp., the small but rapidly expanding California-based maker of popular drinks such as Monster Energy, Hansen's, Blue Sky and Junior Juice. With its stock up 1,671 percent over the past two years, Hansen Natural recently announced a 2-for-1 stock split.

But because the dominance of small-capitalization stocks over large caps is in its sixth year, some experts are reminding investors that a typical small-cap cycle lasts just five or six years. Time may be running out for the Hansen Naturals of the world as the stocks of larger companies shove them aside.

Not so, insists Jim Collins, editor of the OTC Insight newsletter and manager of a $750 million small-cap investment portfolio that profited from that beverage company's rise.

"It's almost a no-brainer that small-cap stocks will continue to lead throughout the rest of this year," said Collins, chief executive of Insight Capital Research & Management Inc. in Walnut Creek, Calif. "A long-term economic growth trend will help small-caps more than large caps, while the dollar rising against the euro will hurt large companies that have European operations."

A successful portfolio of small caps, loosely defined as those with market capitalizations under $500 million, is always a mix of stories. Collins also owns stock in True Religion Apparel Inc., whose stylish denim jeans and jackets sell for more than $200 at upscale retailers; Todco, a leading oil and gas driller, and Building Materials Holding Corp., a supplier to contractors and homebuilders.

"Even though consensus thinking has switched over to large caps in the last six months, I think small caps are going to continue to dominate," said James Paulsen, chief investment officer for Wells Capital Management in Minneapolis. "Small-cap stocks have simply made a run from being absurdly cheap to having an equal valuation with large-cap stocks."

During the past 12 months the Russell 2000 small-cap index has gained 22 percent and the Nasdaq composite index 15 percent, while the large-stock Standard & Poor's 500 rose just 12 percent.

"Here we are in year six of a small-cap cycle and it turns out that the valuations of this asset class actually remain quite attractive," said Satya Pradhuman, small-cap strategist for Merrill Lynch & Co. in New York. "The punch line is that smaller firms are growing faster than large firms, and that is what the market is going to chase."

Access to capital remains excellent for smaller firms, so their positive stock trends should continue, Pradhuman said.

Anixter International Inc., a distributor of wire, cable, networking products and fasteners, is on the Merrill Lynch "buy" list. So is ZymoGenetics Inc., a biopharmaceutical research company spun off from Novo Pharmaceuticals.

Small firms are sensitive to interest rates, although some experts believe the Federal Reserve may be just about done with its rate boosts.

Investor caution has given way to optimism, Paulsen believes, so the market should be led higher by technology, cyclical and small-company stocks.

"A lot of analysts who called for the demise in the leadership of small- and mid-cap stocks were wrong," said Sam Stovall, senior investment strategist for Standard & Poor's Corp. in New York. "If something works, investors stay with it, and they haven't been disappointed by returns of these stocks."

Small-cap stocks outperformed large caps over a 10-year period in the 1970s stretching into the early 1980s, Stovall noted, so there is a precedent for extending the typical cycle.

S&P recommends Audible Inc., a maker of downloadable audio versions of books; Steak N Shake Co., a full-service chain of 430 restaurants; and Finish Line Inc., a maker of athletic footwear operating more than 600 mall stores in 46 states.

Keep in mind these are still volatile stocks in companies that don't have the financial wherewithal of their larger brethren, so experts advise investors to either buy a basket of small caps or a fund that specializes in them. They shouldn't dominate your personal portfolio, they said.

"Small caps represent 12 to 15 percent of the pie in the U.S. equity market, so you should have 10 to 12 percent of your portfolio in them, which is a little underweighted," said Steven DeSanctis, director of small-cap research for Prudential Securities in New York.

Among small caps, value stocks have outperformed growth stocks for five of the past six years, a trend that DeSanctis expects is going to reverse.

Insight Capital also recommends stock in Orckit Communications Ltd., an Israeli manufacturer and marketer of telecommunications equipment for the transmission of broadband services, and Marvel Technology Group Ltd., a semiconductor company whose products are used in consumer electronics games.

Andrew Leckey is a Tribune Media Services columnist.

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