- The Washington Times - Wednesday, November 17, 2004

Small-cap stocks have enjoyed a stellar run the last several years, a trend some analysts believe will continue in the months ahead. But mutual fund investors should consider their options carefully before chasing this asset’s sizzling performance, as there’s little doubt the cycle is starting to wane.

Last year, the Russell 2000 index of smaller companies surged 47.3 percent, versus a 28.7 percent rise in the large-cap Standard & Poor’s 500. Small caps have doubled the performance of large caps so far this year, as well; the Russell index, currently trading at new highs, is up 10.95 percent year-to-date, while the S&P; 500 has gained 5.71 percent.

The current small-cap cycle, which began in 1998, is now in its sixth year. With the typical cycle lasting from five to seven years, many on Wall Street are skeptical about how much longer small-cap stocks will be able to outperform large-cap stocks. But small-cap cycles have been known to last as long as 10 years, depending on market conditions. Researchers with Standard & Poor’s say a number of factors, including low interest rates, rising commodity prices and strong fundamentals, could help extend the current small-cap streak.

“There’s been a lot of talk lately that the small-cap cycle is coming to an end, but the rationale for that has been just the length of the cycle. We think there’s more to the story than that,” said Richard Tortoriello, an equity analyst with S&P.; “When you look at valuations, earnings growth, the low cost of capital, the low interest rates and the easy access to money … plus the fact that small caps continue to outperform, we think they have further potential.”

Mr. Tortoriello and fellow analyst Massimo Santicchia reviewed all the major small-cap cycles going back to 1970, and found that in addition to valuations, the cost of capital is a key driver of small-cap performance. During the lengthy period of low interest rates, small companies have been able to obtain loans and refinance debt at very favorable rates. They found that rising commodities prices are also associated with small-cap outperformance, most likely because of their exposure to the industrials and materials sectors.

But with rates on the rise, Mr. Santicchia said, “conditions can only get worse from that point of view.” Indeed, any shock to the system — a sharp drop in the dollar or any radical event — would likely have an outsized impact on small-cap stocks.

So, while small-cap stocks may continue to do well for several more months, particularly as the market enters a seasonally strong period, most analysts agree it’s not a good time to be raising your stake. For individual investors, that means choosing securities carefully and watching for changes in market conditions that might negatively affect small-cap stocks, such as a sharp rise in interest rates. That could be a signal that it’s time to migrate toward higher-quality large-cap stocks.

Most individual investors should maintain exposure to both large- and small-cap stocks at all times, regardless of what’s going on in the stock market. A good strategy might be to maintain a long-term asset allocation that’s consistent with market value weightings, said Jim Peterson, vice president of the Schwab Center for Investment Research. A “neutral” allocation such as this would call for about a 3-to-1 ratio of large caps to small caps in the equity portion of your portfolio, or roughly 30 percent in small caps. Changing market conditions might lead you to add or subtract from that neutral position over time, but to avoid taking on too much risk, it would be wise to stay within 10 percent of your long-term allocation, Mr. Peterson said.

“Right now, we don’t feel there’s any strong reason to tilt away from a neutral allocation,” Mr. Peterson said. “On the one hand, we think the small-cap cycle has played itself out, but at the same time we think the market has a few good months ahead of it. In another few months we might be saying ‘OK, it’s time to tilt away from small caps.’ But we’re not there yet.”

If you’ve neglected the small-cap portion of your portfolio or have been unaware of their relative outperformance so far this year, it’s a good time to reassess your allocation and collect profits if you’ve strayed too far from your long-term position. Given that small caps likely are facing a slower period ahead, it’s wise to make sure you’re diversified, and not leaning too much toward more volatile growth stocks.

Index or exchange-traded funds that track the Russell 2000 or the S&P; 600 can offer cheap, diversified exposure to small-cap stocks. But many financial planners say indexing is a less-compelling option in this asset class than it is in heavily researched large caps, where it’s more difficult for active managers to gain an edge.

When choosing a small-cap fund for your portfolio, look for those with strong three- and five-year track records and low expenses. Mr. Peterson, of Schwab, is fond of those that are somewhat undiscovered, as they are more likely to have lower asset levels, which may make it easier for the fund manager to put money to work.

For an investor who is interested in monitoring exposure to value and growth, Mr. Peterson recommends pairing two funds, such as the American AAdvantage Small Cap Value and the more growth-focused Baron Small Cap.

Both have solid performance records, and the Baron fund has lower volatility compared to its peers because it shies away from the most aggressive growth stocks.

For one-stop shopping, Mr. Peterson recommends looking for a fund with exposure to both styles, and to be watchful of those that have strayed into larger mid-cap stocks.

After such a long run of outperformance, a good deal of money has flowed into small-cap stock funds, pushing asset levels to uncomfortable highs.

Some funds have responded by closing, while others have strayed into the midcap area as their managers looked for new ways to put money to work.


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