- The Washington Times - Wednesday, May 14, 2003

As the economy moves forward uncertainly, many financial planners say small-cap growth stocks - often considered somewhat risky and volatile for average investors - could be the big winner in the months ahead.

Small caps, which have a market value of about $1.5 billion or less, often perform quite well after a war or recession. Planners say that is one reason to consider the investments, especially for those who invested heavily in larger blue-chip companies for safety and stability during the bear market.

“Our thesis has been to get more aggressive, with a belief that small-cap growth will outperform,” said Steven DeSanctis, director of small-cap research at Prudential Securities. “That means technology, health care and consumer services are places we find attractive.”

Indeed, since 1946, smaller-cap stocks had an average one-year return after recession of 37.8 percent, compared with a return of 23 percent for large-cap stocks, according to Ryan Beck & Co. in a recent report touting small caps.

And this year, the Russell 2000 index, a common benchmark for smaller-company stocks, has outpaced the gains for the Standard & Poor’s 500 index and the Dow Jones industrials, although it lags the Nasdaq Composite Index.

Still, it’s not clear how much attention investors may be paying. Small-cap growth funds had outflows of $1.2 billion this year, although that trend may be reversing itself, according to AMG Data Services. There were inflows of $1.1 billion last month.

In contrast, the average equity fund has had inflows of $7 billion this year, powered by a surge into large caps, AMG Data said.

“Small caps are still decently valued compared to larger-cap stocks because of the big run-up of large-cap stocks in the late ‘90s,” said Vernon Lee, a financial planner in Raleigh, N.C.

Analysts say several factors make small caps attractive. As the U.S. economy recovers, smaller companies often see more explosive growth than bloated, large companies with wide-ranging as well as international businesses.

The investments are less prone to accounting scandals that have wreaked havoc on large companies such as Enron and more recently HealthSouth, in part because smaller companies’ less-diversified businesses make it more difficult to hide accounting improprieties.

Mr. DeSanctis also says small caps could benefit from what he expects to be a pickup in mergers and acquisitions in the months ahead as corporate credit continues to improve and interest rates remain low.

“If large-cap earnings growth doesn’t look as good going forward, we may see them buy beaten-up small-cap names,” he said.

Still, the investments remain risky. Just as small companies could see huge growth should their niche products succeed, they also lack other businesses to cushion losses in case of failure. That was seen in the late 1990s with Internet companies after the tech bubble burst.

Much of small caps’ promise rests on the premise of an economic recovery, which is not yet certain. More terror attacks, wars or even tepid corporate spending could lead to a double-dip recession, which would hurt smaller businesses more.

And small caps don’t pay dividends, which could make them prone to some sell-offs should Congress pass a version of President Bush’s proposed dividend tax cut and investors shift their dollars to dividend-paying large caps.

Financial planners suggest that investors consider devoting 15 percent to 30 percent of their stock portfolio to small caps. While small-cap growth seems to have the most promise, owning a mix of growth and value funds remains the best bet, they said.

“The market is so choppy now and there’s so much uncertainty, I think the best advice is a diversified portfolio,” said Phil Edwards, managing director of funds research at Standard & Poor’s.

“There’s no complete safe haven. It’s not like we can find a pocket and hide in it,” he said.


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