Small Cap Stocks: Searching for the Stars of 2010

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Although Congress is trying to strong-arm big banks, particularly former TARP recipients, to increase lending to small businesses and prospective home buyers, the availability of credit to all but the most robust and larger businesses isn't expected to improve meaningfully.

"There are small-cap companies that have good balance sheets, that don't need to go to the credit markets as much as you might expect," says Adriana Posada, senior portfolio manager of the American Beacon Small Cap Value Fund (AVPAX). "So we think there's room for both large and small to do well next year. It will be a stockpicker's market."

debt-free, small-cap equipment makers

For Boniface Zaino, portfolio manager of the $1.6 billion Royce Opportunity Fund (RYPNX), a company's debt level and the amount of cash on its balance sheet are key measures. Even though 2010 is expected to be a hard slog for consumer discretionary stocks, Zaino says it's possible to find good merchants with products that are attractive to certain kinds of consumers. He likes dELiA*s (DLIA), whose apparel appeals to teenage girls. The company has no debt and $50 million in cash on its balance sheet.

In the tech sector, Zaino likes smaller manufacturers of capital equipment such as Brooks Automation (BRKS) and Cohu (COHU), both of which serve the semiconductor industry. Each stock trades a little above book value, has no debt, and should show dramatic upside in earnings as business improves.

The Semiconductor Industry Assn. has projected a 10.2% hike in global semiconductor sales to $242.1 billion next year, an 8.4% increase, and on to $262.3 billion in 2011, following an estimated 11.6% decline in 2009.

Lauren Prince, a financial advisor to business owners, high-net-worth individuals, and retired people, thinks it's always a good time to buy small-cap stocks. Small businesses are known for being innovative and helping pull the economy out of recessions, she notes. Even if they have limited access to the credit markets, they should be able to find private investors who are looking for good ideas in which to put money to work. She keeps a 4% weighting in small-cap value and a 3% weighting in small-cap growth in the average client's portfolio. She likes to use the Royce Special Equities Fund (RYSEX) for the value component and the T. Rowe Price New Horizons Fund (PRNHX) for growth.

modest volatility in small caps

With small-caps starting to recoup some losses from the October-November period, Prince considers this a good time to be dollar-cost averaging into smaller stocks.

Bank of America's Dec. 11 note also cited higher intraday volatility inside the Russell 2000 index than in the S&P 500 index as another reason to be wary of smaller stocks right now. But volatility overall is very low,

On Dec. 18, implied volatility (popularly known as the VIX) for the S&P 600 index was 23.7, not much higher than the volatility reading of 22.2 for the S&P 500 index. The fact that there's no incremental implied volatility in small caps vs. very large caps "signifies a level of complacency which is endemic in the current system right now," says Nicholas Colas, chief market strategist at BNY ConvergEx.

"One thing that small and large caps have in common now is that people are awaiting fourth-quarter earnings" and expecting to see growth for both revenue and profitability for the first time in over a year, he says. "The market is discounting the full upside of fourth-quarter earnings."

In order for the market to move higher in the first quarter, companies not only would need to meet their sales and profit forecasts but also start providing guidance again for future earnings, he says.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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