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Simple secret may explain mystery of small stocks

One of the loudest sounds to be heard in the stock market's May-June sell-off was the thud of small stocks falling from favor.

In a clamorous five-week stretch from early May through mid-June, a popular U.S. index of small stocks tumbled almost twice as hard as its big-stock counterpart. The Russell 2000 Index lost more than 12 percent while the Russell 1000 Index dropped 6.6 percent.

Since then, each has recouped part of its loss. Through the middle of this week, that left the small-stock 2000 with a net decline since May 9 of 7.6 percent, compared with a drop of 3.9 percent for the big-stock 1000.

Many voices have hailed this as a long-overdue moment of enlightenment -- a realization dawning on investors that they have carried on their latest infatuation with small stocks too far for too long.

From the end of the 1990s through the end of 2005, the Russell 2000 climbed 44 percent, including dividends, while the Russell 1000 lost 2.7 percent. That works out to the Davids trouncing the Goliaths by more than 6.5 percentage points a year.

According to Bloomberg data, this disparate showing left the price-to-earnings ratio of the small-stock index at 37-to-1 at last report -- about twice the 18 multiple of the big-stock index. While small stocks, with their presumably greater growth potential, are traditionally accorded a somewhat higher P/E ratio, anything that amounts to double or more is pretty extreme.

Trading places?

If most things in finance sooner or later revert to their mean, big stocks must be primed and ready to take over the spotlight, right? I'll be the first to say it's hard to disagree with that argument.

That doesn't mean, though, that one must swallow it whole, selling every small-stock fund one owns and going 100 percent into big stocks. Speaking as one who has rebalanced some money out of small-stock mutual funds this year, I see a strong argument for keeping the rest of my small-stock stake right where it is.

More than two years have passed since sharp-penciled analysts began touting a switch away from small stocks. As time has passed and the changeover hasn't happened, the proclamations have only grown louder, to the point where hardly anybody is left beating the drum for small stocks. In investing, strong consensuses are always to be distrusted.

"Doesn't everyone think the small caps aren't going to outperform any more?'' remarked Irene Hoover, manager of the $495 million Forward Hoover Small Cap Equity Fund, at a recent Morningstar Inc. (Nasdaq: MORN) investment conference in Chicago. "So then how can that be true?''

Extra edge?

Beyond sheer contrarianism, one can sense a simple logic behind small caps' persistent strength -- a strong logic that might well continue to support them in months and years to come.

This view holds that small companies, by their very nature, can take advantage of changing economic conditions and opportunities better than big companies. Being small and in many cases new, they are less concerned with protecting what they have built in the past. And in an increasingly information-based world economy, the pace of change gets faster all the time.

"One can argue that the sharper rate of change in the global economy is tilting the challenger/incumbent balance even more dramatically in favor of the challengers,'' writes Michael Mauboussin, chief investment strategist at Baltimore-based fund manager Legg Mason Capital Management, in his new book "More Than You Know: Finding Financial Wisdom in Unconventional Places'' (Columbia University Press, 288 pages, $27.95).

Speeding up

"The aggregate returns of the stock market indexes belie an accelerating rate of change as young innovators unseat their established competitors,'' Mauboussin says. "Corporate longevity is on the wane.''

None of this is to claim that small stocks can't face an extended slump. In the 1980s, a decade that featured plenty of innovation in its own right, the Russell 2000 had to settle for a 7 percent annual gain from the end of 1983 through 1989 while the Russell 1000 climbed 13 percent a year.

Over the past 25 calendar years, Bloomberg data show the two indexes have posted virtually identical 9.2 percent-a-year gains, not counting dividends. In the next 25 years, small stocks may hold an important edge.

Currier is a Bloomberg News columnist. His opinions are his own.

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