Think before following the herd to small-cap stocksYou'd expect smaller-company stocks to be bolstering portfolios now, but some analysts are warning investors to be careful.
By: Gail MarksJarvis, Chicago Tribune
You'd expect smaller-company stocks to be bolstering portfolios now, but some analysts are warning investors to be careful.
So-called small-cap stocks typically are the market's best performers in the first and second years of an economic recovery, and they've played their part on cue this time. But with the small-cap Russell 2000 index climbing 110 percent since the March 9, 2009, low point in the market, analyst Steven DeSanctis of Bank of America Merrill Lynch is asking if it's "too good to be true."
He told clients this week that the rally has been one of the strongest ever, and such a tremendous climb "tends to bode poorly for subsequent performance."
Other analysts also are growing uncomfortable with the tremendous run-up when large companies in the Standard & Poor's 500 index are up 78 percent over the same period.
"Investors should not overstay their welcome in small caps," warned Oppenheimer & Co. strategist Brian Belski.
It's not just those numbers that concern analysts. Many of the stocks giving the market rally its punch are lacking profits, the ingredient that typically bolsters shares long term. Small-cap companies with no earnings have climbed 138 percent, while those that have been profitable are up about 78 percent, DeSanctis said.
Adding to the apprehension are overall earnings estimates, which are starting to edge lower, DeSanctis notes.
"This could be a turning point in performance," he said.
Still, small caps have a powerful force on their side — momentum, or popularity with the crowds. Many investors, including 401(k) participants, have been adding cash to small-cap funds, and, because of the companies' size, the effect of a little money in small caps is magnified compared with large companies.
Even though many analysts consider small-company stocks to be expensive, and consequently set up to fall if investors grow nervous, momentum can carry the group for a long time, said Leuthold Group analyst Eric Bjorgen.
His firm was concerned about large companies — especially technology — becoming expensive in 1997, but momentum carried them higher for about three years before the stocks plunged.
Despite some concerns about small-cap valuations, the Leuthold Group recently added a little more exposure to them "to provide juice" to returns, Bjorgen said. But he views it as a short-term move: The firm's model stock portfolio has only about 2.2 percent in small-company stocks, compared with the typical 6 percent.
Bjorgen said the greatest opportunities now could be in mid-cap stocks. The firm generally puts about 20.4 percent of its portfolio in medium-size companies, but it has raised that to 31.7 percent.
Typically, shares of the smallest companies are the leaders coming out of a recession because the firms are nimble, lean, and attractive to acquirers. It's also not uncommon for stocks with no earnings to climb powerfully coming out of the downturn.
Standard and Poor's chief investment strategist Sam Stovall notes that "the worst become first" as investors buy the survivors that they had expected would collapse in the recession. At first, prices on the survivors are cheap.
Now, DeSanctis said, small caps overall stand at 16.7 times forward earnings estimates, compared with the 14.8 percent historical average.
Belski notes small caps have outperformed large stocks by 12 percentage points during this recession, compared with 1 percentage point for all other recessions since 1980 and 5.7 percentage points in the 2001 downturn.
"We believe this reflects the dramatic increase in investors' risk appetite over the past several months," he said.
Small-cap fund managers also may be feeling pushed to become more risky.
Many of the stocks that fund managers have been reluctant to buy have been the highfliers, and consequently only 35 percent of small-cap fund managers have been beating their benchmark index — a position that is not good for attracting clients or keeping managers in good standing.