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If you think the Dow Jones industrial average has taken a bad hit recently, just take a look at the Russell 2000, the widely followed index of small-cap stocks. It has lost 28% since its high on Apr. 22 and is down 19% since Jan. 1. Compare that with losses for the blue-chip Dow--down 15% since its high on July 20 and up 0.46% since the beginning of the year.

As the stocks of many small-cap companies have crashed and burned, the sector has plunged into a bear market. But you won't hear those words on the lips of many small-cap mutual-fund managers. Instead, they see the recent sell-off--which has brought some favorite stocks down 50% from their highs--as a reason to celebrate. ''I'm buying every day,'' says Ronald Baron, who runs the $4.4 billion Baron Asset fund. ''There has been no change in business fundamentals, only the stock price.''

''WITH A VENGEANCE.'' Managers such as Baron believe that when third-quarter earnings come out at the end of September and investors see that the stocks of many companies with small capitalizations were beaten down unjustly, the sector could rally. Jim Awad, co-manager of the Heritage Small Cap Stock fund, is even more bullish: ''We're going to shift into a small-cap rally with a vengeance.'' Why? A lot of people continue to buy big-cap blue chips every time they weaken, says Awad. But that buying sentiment is growing weaker, as shown by the dwindling height of each successive recovery. As a result, he maintains, ''people will look for a new way to make money.''

Maybe Awad is overstating the recovery case a bit. Other small-cap pros are more cautious, as well they should be. Even the small-cap funds awarded three stars or better by Morningstar for their five-year returns have seen disastrous declines this year (table). But Robert Perkins, manager of Berger Small Cap Value fund, maintains that ''when small caps come out of a correction, the reward is much greater'' than for large caps. In anticipation of such a reward, Perkins has cut the amount of cash in the fund from 20% three months ago to 6% as he trolls for bargains. Among his recent buys: Brooks Automation (BRKS), a manufacturer of semiconductor gear that is selling at 9, down from 41 last fall. Brooks is debt-free, and revenues are rising at 15% annually.

For many managers, the underperformance of the small-cap sector is easily explained. Wall Street's bull market has been fueled largely by America's love affair with index funds, which are composed mostly of blue chips. Investors also typically shift into stocks with market capitalizations exceeding $5 billion toward the end of an economic cycle. That's because large issues have greater liquidity than small caps, a feature that offers a margin of safety if the economy falls into recession and the equity market retreats.

But small companies usually do much better once the economy emerges from a recession, notes Thomas Maguire, the manager of Safeco Growth No Load fund. Take 1990: Small caps performed dismally, as the Russell 2000 fell 22%, compared with a decline of 6.5% for the Standard & Poor's 500-stock index. Investors got a nice bounce in 1991, when small caps returned 44%, compared with 26% for the S&P.

Of course, with the economy still strong even in the face of global financial turmoil, it's debatable whether the U.S. economy is flirting with recession. But many small-cap prices already reflect that possibility. While few managers are willing to say small caps have hit bottom, most agree that current valuations are too attractive to pass up and will certainly pay off over time. ''We're paying what we think is cheap, with full recognition that the stock may get cheaper,'' says Peter Larson, the manager of Galaxy Small Cap Value fund. Larson is bullish on Callon Petroleum (CPE), a small oil-exploration company that has had a string of recent successes. The stock is selling at 2.5 times cash flow, and Larson thinks it could sell at a multiple of 5 within 6 to 12 months. Callon's stock fell from 16 in December to a recent 8, when Larson bought in.

EXPANDING UNIVERSE. Heritage's Awad looks for companies that he expects to have consistent, above-average earnings growth and that he can buy at a price-earnings ratio one-third lower than that of the S&P 500, currently at 24. He has added to his holdings of Sun Healthcare Group (SHG), an acute-care nursing-home operator that's trading at a p-e of five times next year's expected earnings of $1.90 per share. It's selling at 9 1/8, off its high of 22 15/16. Awad also likes Doral Financial (DORL), a bank holding company that has a dominant share of the mortgage market in Puerto Rico. It's selling at a p-e of 13, based on 1999 estimated earnings of $1.30 a share. He bought at 12, off its high of 20 3/8.

Roger Glenski, co-manager of Wachovia Special Values, looks for stocks selling at deep discounts, especially those of companies with operational problems that he expects to be fixed soon. In this market, ''good businesses without problems have gotten punished, so my universe has expanded,'' says Glenski. He has whittled his 15% cash position prior to the sell-off down to 10% by purchasing stocks he previously thought were too expensive. Among them are Racing Champions (RACN), which makes and sells collectibles affiliated with the booming NASCAR racing market. He expects the company to earn 90 cents a share this year. He bought it for 9, off from 13 1/2 at the end of July. He also likes A.O. Smith, a manufacturer of motors for such household appliances as air conditioners, washers, and dryers. It's a high-margin business that is doing well in a strong housing market. He snatched up shares at 20, down from the high of 35 7/8 in mid-July.

The most cautious one of the bunch is Michael Fasciano, and it shows in his returns. His Fasciano Fund has had the smallest year-to-date decline--just 1.48%. His cash position rose from 3% at yearend 1997 to 20% by June 30, in part because he sold some shares and didn't aggressively buy new stocks. ''I'm not trying to do anything too bold,'' says Fasciano, who looks for companies that can double their sales and earnings within three to five years. He recently added to his position in Chicago Title (CTZ), the No.1 title-insurance company in the U.S. It has strong earnings, a low p-e, and is flourishing as low mortgage interest rates spur a boom in home sales.

Even if the small-cap sector continues to slide, it's important to realize that because these stocks are so illiquid, prices can fall too far and then shoot up once the market turns. That turn may not be in sight yet, but small-cap bulls are starting to load up before any rally begins. They think prices have come down so much already that adding some small-cap stocks or funds to your portfolio now can't be a bad idea.

By Toddi Gutner


TABLE: How the Top Small-Cap Funds Have Retreated


Updated Sept. 17, 1998 by bwwebmaster
Copyright 1998, Bloomberg L.P.
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