At a time when stock markets have been buoyed by some positive economic data, small-cap stocks have whipped their larger brethren over the past three months.
At a time when stock markets have been buoyed by some positive economic data, small-cap stocks have whipped their larger brethren over the past three months. But those who watch small-cap companies closely say such companies — particularly small-cap financials — may be hit hardest if the economy begins to slip again.
As of last Tuesday, the Russell 2000 Index, which tracks small-cap stocks, was up 14.4% from its low for the year March 10. Over the same time period, the Standard & Poor's 500 stock index rose 6.1%.
One of the reasons small-caps have rallied so much is that they were especially battered when the credit crunch was in full swing. Investors shunned smaller stocks during those months simply because they tend to be riskier than bigger-name companies.
"The baby really got thrown out with the bath water," said J. Bryant Evans, portfolio manager at Cozad Asset Management Inc. of Champaign, Ill., which manages $600 million. "[Small-caps are] often companies that people don't know a lot about, and perhaps that is why they all went down so much with little regard to fundamentals."
That trend reversed in March, with the Federal Reserve-brokered sale of The Bear Stearns Cos. Inc. to JPMorgan Chase & Co. Both companies are based in New York. Investors gained more confidence in the market, and credit spreads started to tighten, which tends to be a boon for small-caps. Narrowing spreads signal a decline in borrowing costs for small companies relative to large companies, since from a lending standpoint, small companies generally are considered to be riskier than their larger counterparts.
Small-cap earnings, while declining, have also bested those of larger companies. In the first quarter, small-cap earnings were down 8.8%, whereas large-cap profits dropped 17%. Steven DeSanctis, small-cap strategist at Merrill Lynch & Co. Inc. of New York, attributes the outperformance by small-caps to the fact that large-cap financial companies took more significant write-downs in the first quarter than smaller banks.
He said that he is wary of smaller companies' continuing ability to perform better than larger companies. "With the economy close [to], if not already in, a recession, and the fact that we are still not completely out of the credit crisis, we are surprised that the small-caps have overtaken the large-caps in the year-to-date race," Mr. DeSanctis wrote in a report.
However, despite the narrowing of high-yield spreads, decreases in volatility and better earnings for small-caps, it's not likely that their outperformance will last.
"The economy has not gotten that much better to justify this leap, in our opinion," said Mr. DeSanctis. "We would like to see how the economy performs the remainder of the year, and get further confirmation that most of the credit crunch is behind us, before we get excited about the prospects for small-caps."
For that reason, small-cap fund managers are treading nervously. "We are trying to be really careful, and not get sucker-punched by the economy and inflation," said Eric Cinnamond, manager of the Intrepid Small Cap Fund of Jacksonville, Fla. Over the past 12 months, the fund has returned 4.64%, placing it in the top 1% of small-cap-value funds, according to Morningstar Inc. of Chicago.
"From a buyer's perspective, we still see a difficult environment going forward," Mr. Cinnamond said.
In addition, according to Mr. DeSanctis, the worst could be yet to come for smaller financial companies. "We think that the credit crisis will last longer for the small-cap and mid-cap financials, and this trend of better earnings will likely revert in favor of the large-caps," he said.
That's one reason, Mr. Cinnamond said, that while he owns some small-cap insurance companies, he is avoiding the banks. "It was not that the small regional banks, during the credit boom, were just sucking their thumbs," he said. "They were out lending aggressively as well."
Mr. Cinnamond said the still-deteriorating credit conditions for the small banks also make them difficult to value from an investment standpoint. "And if we can't value something, we won't buy it."
It's also possible that another shoe will drop in terms of the economy. "We're still in the middle of the credit mess," Mr. Evans said. "And are inflationary pressures, high-gas[-price] pressures, as well as rising unemployment and a general decline in consumer sentiment, going to cause a real economic problem? If they do, small-caps can go down from here."
However, if things don't turn out too bad, Mr. Evans said, small-caps will be a real buying opportunity. He pointed to the fact that on average, small-caps are still profitable, have compelling dividend yields and, on a forward price-to-earnings basis, are trading around 15 times earnings.
"To me," Mr. Evans said, "that tells me that things are not out of whack for small-caps."
Megan Johnston is a reporter at sister publication Financial Week.
