Posted by: Ben Steverman on April 5, 2010
Why are smaller companies so thoroughly beating big companies in the stock market?
With a median market capitalization of $466 million, the small-cap Russell 2000 index is up 11% so far this year. The large-cap Russell 1000 index — median market cap $4.1 billion — is up 6.8% this year. Both indexes gained about 25% last year.
Here are some possible reasons:
1. Investors are willing to take risks, hoping for big returns from troubled companies.
Bank of America Merrill Lynch (BAC) small-cap strategist Steven DeSanctis writes in an Apr. 1 note that the top performers continue to be the lowest-quality stocks. Among the leaders are companies with share prices of $5 or less, with no earnings, with low return-on-equity and with the lowest market values.
2. Merger and acquisition activity is expected to pick up.
Quincy Krosby, Prudential Financial (PRU) market strategist, thinks investors are trying to get out ahead of an uptick of buyout activity. Smaller companies should be attractive M&A targets. “Many of those names are going to be taken out,” she told me.
3. U.S. investors want to stay close to home.
Smaller U.S. companies tend to get more earnings and sales from the U.S. The large-cap stocks in the S&P 500 get 31% of their revenue from outside the U.S., according to a Mar. 1 estimate from Morgan Stanley.
Fiscal and economic troubles in Europe are scaring investors, says John Merrill, chief investment officer at Tanglewood Wealth Management. The buying of small caps “was mainly a flight to America away from Europe and other areas,” he said in an interview.
4. Follow the herd.
Krosby suggests many buyers of small-cap stocks might be just “chasing performance.” In other words, they’re piling onto small caps because they expect their momentum to continue.
Eventually, though, the small-cap run will end. Krosby is betting larger, dividend-paying companies could be the beneficiaries.