One look at the plunging line on the Washington area stock chart below is graphic evidence of what has happened to local stocks during the last four weeks. The losses were shared by the relatively small, over-the-counter stocks that make up 63 percent of the Washington area group. Worse yet, the ordeal for small stocks may not be over.
Over-the-counter stocks are entering "the period of maximum stress," says Preston G. Athey, a specialist in small company growth stocks at T. Rowe Price Associates, the Baltimore mutual fund company.
Already badly battered by the market's recent collapse, many OTC stocks are likely to remain under pressure between now and the end of the year, Athey said.
The reason, he said, is that we are moving into tax-selling season, when investors unload stocks that have performed poorly so they can report their losses on their tax returns.
Historically, Athey notes, "OTC stocks get hit harder than other stocks" during tax-selling time, which lasts until Dec. 31.
After New Year's Day, Athey says, there is a chance that OTC stocks will begin to bounce back -- especially if investors take part in the traditional January buying spree.
But Athey isn't willing to bet the farm on it.
"I don't have any answer for when it is going to turn," he said.
Athey's caution is borne out of long experience with stocks of small companies -- mostly stocks traded in the Nasdaq over-the-counter market. Athey formerly presided over the New Horizons Fund and recently has become president of the new Science and Technology Fund. He also continues to handle investments in small companies for pension funds managed by T. Rowe Price.
Athey has been waiting a long time for small company stocks to stage a vigorous rally. Since mid-1983, the small company stocks have lagged behind the blue-chip market.
As of Sept. 30, the Standard & Poor's 500 stock list had gained 35.85 percent for the first nine months. Stock funds, as a group, were up only 29.4 percent. But the small company growth funds were even further behind. They were up only 26.2 percent.
According to an old rule at New Horizons, the stocks in the fund were supposed to rise more than the market when the market was going up and were supposed to fall more than the market when the market was going down.
That rule was broken between 1984 and 1987, when the S&P 500 rose twice as fast as the fund's smaller stocks. Unfortunately for New Horizons, the rule worked very well on the downside.
After the market's plunge, the condition of the three groups looked like this: For the 10 months ending Oct. 30, the S&P 500 was up 6.4 percent while all stock funds were down 3.4 percent and small company funds were down 14.5 percent.
Why did the small stocks get hit so much harder than other stocks?
"The number one problem," said Athey, "is that when you have a market crash, the risk tolerance of investors changes. Their aversion to risk increases. And small, high growth stocks are seen as more risky than shares in larger companies." That sends investors rushing to the phones to sell.
But there were other reasons for the rapid descent of OTC stocks, Athey believes.
The overwhelming crush of sell orders that hit market makers -- traders who buy and sell stocks for clients in the OTC market -- created a situation in which some traders put a limit on the number of shares they would buy, chiefly because they had limited amounts of capital they could risk.
As a result, Athey said, some traders lowered prices precipitously to try to attract buyers and avoid losses.
At the heart of the problem, Athey said, was "a lack of liquidity" that led to sharply lower prices in an environment where everyone wanted to sell and hardly anyone wanted to buy.
As for the current value of small company stocks, Athey said, the buying opportunities "scream out even louder than in the past." But he is aware that many investors are saying "So what?" because they are simply tired of waiting for the rally in small stocks.
One measure of the value of a stock is the relationship between its market price and the company's annual profits or earnings per share. It is called the price-earnings ratio and can be calculated by dividing the price of a stock by its annual earnings per share. A $24 stock with $3 a share in annual earnings will have a PE ratio of 8.
Normally, stocks of rapidly growing companies sell at price-earnings ratios that are considerably higher than PE ratios for blue-chip companies. At some points in the past, they have been as much as 100 percent higher.
One reason small company PEs are higher then large company PEs is that investors are willing to pay more for every dollar of profits made by a small company growing at 40 percent a year than for the profits of a large company growing at 20 percent a year.
Last June, the PE ratio for New Horizons was only 30 percent higher than the PE ratio for the Standard & Poor's 500. That made New Horizons look cheap compared with the levels of earlier years.
Then stock prices plunged and the PE ratios of the fund and the S&P 500 each fell to 14. Thus, both the New Horizons stocks and S&P stocks became cheaper together.
But, in the process, New Horizons also lost its 30 percent premium over the S&P 500, making the fund cheaper yet. But there's more.
Looking ahead, Athey said, the outlook for the next 12 months is that the New Horizon's PE ratio will fall about 5 percent below that of the S&P 500. That's only the second time in the fund's 27-year-history that its PE ratio has fallen below that of the S&P 500.
All of the above creates a fundamental dilemma for a would-be investor. By almost any measure, New Horizons shares appear very cheap. But the question is, how long will be it before they are worth any more? Athey admits that while the value case is strong, it could be quite a while before the stocks turn up.
Anyone who buys into the fund or into similar small over-the-counter stocks has to be prepared to invest for the long haul, Athey said.
One small irony is that about the only thing likely to help the fund move up anytime soon is the intention of 30 companies in the New Horizons portfolio to buy back their own stock because they feel the shares are so cheap.
Among the investing public, however, there seems to be little interest in small company stocks because they have been beaten down so hard. Few investors like to tie up their money for a long time without any sign of progress. While patience is a virtue, many feel, it can be very costly.
Mercantile Bankshares and USF&G Corp., both headquartered in Baltimore, have been added to Alex. Brown & Sons' new "emphasis list," which the firm says contains "those stocks we consider most attractive at any particular point in time." The brokerage house makes a market in Mercantile Bankshares and handled a recent public offering for USF&G.
This is how Alex. Brown analysts rate Mercantile Bankshares, a Maryland bank holding company: "Its growing and stable operating market, clean asset base and high level of profitability offer superior quality at a bargain price." Mercantile shares, which have sold as high as $47.25 and as low at $28 in the past year, recently traded at $31.75. At that price, the stock is selling at 8.8 times the estimated 1987 per-share earnings of $3.60 and 7.9 times the estimated 1988 earnings of $4 a share. The stock yields 3.4 percent on an indicated dividend of $1.08.
Alex. Brown's opinion of USF&G Corp., a major property-casualty insurer, was: "Improved underwriting results should bolster cash flow and drive record earnings in 1987 and 1988; hedged equity portfolio and attractive dividend yield provide downside protection." USF&G, trading between $48.75 and $26.25 in the last year, recently sold at $33.63. The analysts estimate USF&G profits will rise from $3.61 per share in 1986 to $5 in 1987, a boost of 39 percent. Looking forward to 1988, they expect a move to $6 a share, for a gain of 20 percent. The stock is selling at 6.7 times the 1987 earnings estimate and 5.6 times the 1988 estimate. With an indicated dividend of $2.48, the stock offers a 7.4 percent yiel