Some expect big rally in small-cap stocks.

August 27, 2011

As the stock market lurched through August and fears of another recession took hold, many investors dived for safety, moving their money into gold or blue-chip corporate giants with large balance sheets.

Not David Wetherell. Betting that the economy will hold up, he went bargain hunting in small-cap stocks.

“A period like August creates a buying opportunity for us,” said Wetherell, who manages a fund at Cozad Asset Management dedicated to small-cap stocks, generally defined as those whose total market value is less than $3 billion.

Small-caps tend to outperform their larger counterparts when the economy is expanding and underperform when it’s shrinking. In the August sell-offs, they were walloped. To investors like Wetherell, that makes them all the more attractive.

While the jury is out on whether the nation is heading for a double-dip recession, the opportunity in these oft-neglected stocks has sparked a lively debate among professional investors.


“If we’re not in an economic recession, we could see a decent rally in small-cap stocks,” said Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch in New York.

Small-cap stocks have lost so much value this year — about 25 percent since their late-April peak, as measured by the small-cap Russell 2000 index — that DeSanctis thinks “flat is the new up”: If they simply end the year where they started, investors will see about a 13 percent rally from where they are now. Large-cap stocks slid about 18 percent in the same period.

Bank of America sees a 40 percent chance of recession, he added.

“That’s really the question that people have to answer for themselves — ‘Do we think a recession will occur?’ ” said Matthew Litfin, a portfolio manager at William Blair who invests in small- and mid-size companies.

Economists have grappled with that possibility in recent weeks. In late July, the Commerce Department said the economy grew at snail’s pace of 1.3 percent in the second quarter and revised its first-quarter estimates to 0.4 percent. A spate of weak reports on manufacturing followed. Then came gloomy figures on housing and consumer spending. And Friday, Commerce revised the second-quarter growth number down to 1 percent.

Not surprisingly, many economists say the odds of recession increased significantly in the past three months. But few are ready to call it — and therein lies the opportunity, experts say, for some diversification into small-cap stocks, best accessed through mutual funds.

Small firms tend to get hit much harder than big ones during economic downturns because they often have less diversified businesses and less cash on hand. That, in turn, gives banks second thoughts about lending them money, which can slow their growth even more.

“It’s very hard for them to get credit and capital,” said Chris Hanaway, portfolio manager at Wells Fargo Advisors. “If we go into another global recession, they will suffer disproportionately.”

The opposite is true in good times. Small companies tend to be at an earlier stage of growth than their bigger counterparts. “It’s the law of large numbers,” said Gary Lenhoff, director of small- cap strategy at Great Lakes Advisors. “It’s harder for IBM or Microsoft to grow as fast — they already have revenues measured in the billions.”

So when money’s pouring in, small companies can plow it back into their business by buying equipment, opening stores or acquiring customers that move the needle on their performance more than similar actions by larger companies can.

“That indeed is borne out by the data over the last 83 years,” said Jay Ritter, finance professor at the University of Florida. From 1927 to 2010, small companies beat large ones by an average of about 0.36 percent a month when the economy was expanding, Ritter said. In downturns, they underperformed their larger peers by about 0.2 percent a month.

The nuance, Ritter said, is that not all small-cap stocks are created equal. Those classified as “growth” investments — companies that are rapidly expanding but have yet to pay out steady dividends — tend to be “a triumph of hope over experience” because they ultimately deliver disappointing returns, he said.

That isn’t commonly the message one finds in newsletters dedicated to the small-cap sector.

“Technological advancements periodically come along that exert a profound influence on not only the business world but also society as a whole,” said a recent issue of Cabot Small-Cap Confidential, a Massachusetts-based newsletter, when it recommended a “big opportunity” to buy Digi International, a small-cap firm that develops communication technology.

“Newsletters like to tout the next Microsoft,” Ritter said, but “Microsoft was never a small-cap stock,” and it is extremely rare for small-cap growth stocks to grow into corporate behemoths. Far more common is for small-cap “value” stocks — those whose business models are proven enough that they can consistently pay out money to their shareholders — to deliver solid returns.

Wetherell uses dividend initiations as one proxy for differentiating between growth and value plays. In January, after Lincoln Educational Services, a for-profit college, initiated a 25-cent dividend, his fund swooped in to buy 8,000 shares. With the recent meltdown, the company’s shares tumbled 50 percent, to $9, meaning it is now paying out an annual dividend of more than 10 percent. The 10-year Treasury bond is paying about 2 percent.

“We tend to like plays that are out of favor,” Wetherell said, so he’s holding on to the company.

Others find small-cap investment strategies, well, laughable.

“They really got creamed!” said Timothy Loughran, who teaches stock valuation at the University of Notre Dame. He chuckled when he looked at a stock chart for Lincoln Educational Services. “I just don’t think small firms are the way to go.”

Loughran thinks investors should set aside the question about a recession and focus more on which emotions will drive the market in the near future.

“I think the market is more likely to continue the flight to quality,” he said, which means large-cap companies like Apple and Google are likely to see more demand for their shares than small-caps. “They’re established, they have lots of product lines, and — most importantly — they have huge amounts of cash on hand.”

DeSanctis, the small-cap strategist at Bank of America Merrill Lynch, concedes that large-cap companies are likely to beat their small-cap counterparts next year because slow economic growth is likely to translate to weak earnings growth — recession or not.

In January, Lori Calvasina, who researches small-cap stocks at Credit Suisse, warned clients to think twice about allocating more money to the sector because small-caps’ valuation relative to large-caps was at a 30-year high. “I’ve basically been the ‘negative Nellie’ all this year, irritating my clients,” she said.

Now, “I’m getting more interested in the sector,” she said, but “I’m not pounding the table by any stretch.”

Why not?

“They’ve fallen, but they’re not cheap, yet,” she said. “And that’s annoying.”

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