Small Stocks' Rally May Pick Up Steam: U.S. Stocks Outlook
June 1 (Bloomberg) -- Small stocks have led the way as benchmark U.S. indexes surged from near five-year lows in March, and investors such as Daniel Bandi are betting the rally has further go.
``They're cheaper, their earnings are better, and they typically do the best as we head out of the bear market and out of the recession,'' said Bandi, who helps manage $26 billion at National City Investment Management Co. in Cleveland.
The Russell 2000 Index, composed of companies with an average market value of $490 million, has jumped 27 percent since the market started rallying March 11, while the Russell 1000 Index, where the average company is valued at $11 billion, has advanced 21 percent.
Even after those gains, the Russell 2000 trades at 14.8 times estimated earnings, according to Frank Russell Co., which created the indexes. The large-stock benchmark is priced at 16.2 times earnings.
Small-company investors also have history on their side: Small stocks on average have outperformed larger issues for at least three years coming out of a recession, suggesting the Russell 2000 may outpace large stocks for another year and a half.
Since 1979, the two indexes typically have been priced about the same, according to Prudential Securities Inc. When one is cheaper, it represents a buying opportunity, some investors said.
Cheaper
``From a valuation standpoint, it makes sense to start looking at small caps,'' said Thomas Laming, whose $1.3 billion Buffalo Small Cap Fund has returned 15 percent annually the past five years, ranking it in the top 1 percent of all funds. His biggest holdings include SanDisk Corp., the largest maker of flash-memory data-storage products, and Strayer Education Inc., a for-profit operator of colleges.
Prudential's Steven DeSanctis, ranked by money managers in Institutional Investor magazine's 2002 survey as the top small- company strategist, said he prefers to value the indexes by comparing prices relative to sales or book value. By those measures, the Russell 2000 also is cheaper than the Russell 1000 Index.
Companies in the Russell 2000 sell for an average of 1 times sales for the past 12 months. Those in the Russell 1000 have a price-to-sales ratio of 1.5.
Relative to book value, or the value of a company's assets minus liabilities, the discount for small stocks is even greater. The Russell 1000's average price-to-book ratio is 2.77, while the Russell 2000's is 1.74.
``If you think economic growth is going to do better, small- cap earnings are going to be better than large cap,'' DeSanctis said.
Benefiting From Growth
Smaller companies often get a bigger boost to their earnings than large companies when the economy picks up and revenue growth accelerates, said Jim Furey, Lehman Brothers Inc.'s small-stock strategist. Smaller companies typically have only one division or product, while larger companies have more divisions and product lines and therefore are less directly affected, said Furey. He said small stocks will outperform large ones for at least the next few years.
Earnings forecasts support that view. Based on the average analyst estimate, Wall Street predicts a 17 percent surge in earnings for small companies in the third quarter versus a 13 percent rise for large stocks, according to Thomson First Call. In the fourth quarter, small-company earnings will climb 24 percent while large-company earnings will rise 21 percent, the survey shows.
``As investors gain more confidence in an economic recovery, they want to play those companies that have more operating leverage,'' said Furey.
Historic Precedent
That may explain why small companies have a history of outperforming as the economy improves.
Since 1945, small stocks returned an average of 75 percent in the three years after a recession, while large stocks returned 52 percent, according to Ibbotson Associates Inc., an investment research firm in Chicago.
Studies by Ibbotson often are cited by money managers as proof that small stocks are a better investment than large companies. By Ibbotson's calculations, the smallest stocks have a compound annual return of 12 percent since 1926, while the S&P 500 has an annual return of 10 percent.
This time around, small stocks have followed the historic norm and outperformed large caps since the last economic contraction. The returns have been muted because of the unique nature of this recovery, investors such as Buffalo's Laming said.
Since the third quarter of 2001, the last time gross domestic product contracted, the Russell 2000 has gained 8.9 percent. The Russell 1000 has lost 6.1 percent since then.
In the 20 months since then, the lack of inflation, the U.S.- led war versus Iraq, and the weaker U.S. dollar have restrained earnings growth for small companies and thus their usual pace of returns, Laming said.
Reversing Trends
Without inflation, it's more difficult for smaller companies to raise prices. The weaker U.S. dollar benefits larger companies because -- unlike many small stocks -- they generate plenty of revenue overseas. A weaker dollar makes their products more attractive in other countries.
Laming is counting on those trends to reverse, boosting small shares further. ``I think most of those things change as we get to the latter part of this year,'' said the money manager, who works in Shawnee Mission, Kansas, for Kornitzer Capital Management.
Bandi of National City recently bought shares of life insurers AmerUs Group Co. and Phoenix Cos. for the firm's $800 million Armada Small Cap Value Fund, which is up 8.6 percent annually the past five years. That ranks it in the top 4 percent of all mutual funds.
The best of the small-stock rally may be yet to come, he said. ``They're still poised to outperform their larger peers,'' Bandi said.
Last Updated: June 1, 2003 10:07
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