Investing: Handicapping the Caps

Small caps have outperformed large-cap issues in the current market upturn, but some analysts believe their ride is nearly over

By David Bogoslaw

As in the early recovery periods following past economic downturns, smaller-size stocks have performed far better than large-cap stocks since the Standard & Poor's 500-stock index hit a low on Mar. 9. The six-month anniversary of that market low is just about a week away, but already some investment strategists believe small caps may have exhausted most of their upside.

The Russell 2000 index, a proxy for small- and mid-cap stocks, jumped 70% between Mar. 9 and Aug. 27, outpacing a 53.4% gain in the Russell 1000 index, which is comprised of large-cap stocks. By an alternate measure, the S&P SmallCap 600 index rose 70.8% and the S&P MidCap 400 index gained 64.92% during the same period, vs. a 54.7% increase in the large-cap benchmark S&P 500 index, according to research outfit FactSet (FDS).

A key exception has been the financial services sector, where investors have clearly felt more comfortable buying big names such as Wells Fargo (WFC) and JP Morgan Chase (JPM) rather than smaller names such as most of the regional banks, whose ability to overcome a large number of bad loans on their balance sheets and survive is less certain.

Recovery Still "Fragile"

A look at the Nasdaq 100 index shows that larger technology companies such as Microsoft (MSFT) and Intel (INTC) have also performed relatively more strongly over the last six months, says Barbara Walchli, portfolio manager of the multicap Aquila Rocky Mountain Equity Fund (ROCAX).

For Jim Dunigan, managing executive of investments at PNC Wealth Management (PNC) in Philadelphia, however, the credit crunch is reason enough to be more conservative on small and mid-cap stocks than he was and would have been coming out of prior downturns. "There's still a fragile nature to this recovery," he says. "We're not that far away from the end-of-world-trade six months ago, so staying conservative on [small and mid-cap stocks] still made sense for us on risk-adjusted a basis."

Small companies' ability to grow will be hampered by comparatively less access to debt and equity capital and to bank lending, Dunigan predicts. But the fact that they have less access to the capital markets or bank credit lines than larger companies makes smaller companies tend to stick more to their basic business, according to Walchli. "They tend to run their businesses so they're generating their own free cash flow," she says. Her fund is currently weighted 55% in micro- and small-cap stocks and the rest in mid- and large-cap companies.

Low Manufacturer Inventories

Many smaller companies design their business model to provide a unique product or service that isn't easily replicated by competitors and that can drive excess returns, she says. That generates more free cash, which they can reinvest in the company or use to make acquisitions.

Since the market bottom, consumer cyclicals, consumer staples, and energy stocks have been key contributors to the outperformance by small and midcaps, says Bruce McCain, chief investment strategist at Key Private Bank (KEY) in Cleveland. In the energy sector, many of the drillers and oilfield service companies tend to be much smaller in size and "we've seen those light up," he says. Part of his strategy has been to sell shares of more defensive energy names such as Exxon Mobil (XOM) and Chevron (CVX) to raise money to buy more shares of smaller energy companies such as Noble (NE) and Transocean (RIG), which he sees as having more ability to grow.

In health care, that quest for higher growth rates has spurred McCain to sell Abbott Laboratories (ABT) in order to buy Covance (CVT) and Henry Schein (HSIC). In retail, the same approach would cause investors to sell a more familiar, safe bet like Wal-Mart (WMT) and buy a smaller, more volatile stock like Urban Outfitters (URBN), he says.

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