With stocks, sometimes bigger is better
If you have been super-sizing small-company stocks in your portfolio, you might want to ask yourself if your eyes are bigger than your stomach. Although small-caps tend to have strong growth after economic downturns, they typically are vulnerable...
If you have been super-sizing small-company stocks in your portfolio, you might want to ask yourself if your eyes are bigger than your stomach.
Although small-caps tend to have strong growth after economic downturns, they typically are vulnerable when the economy slows. With corporate profit growth losing steam, analysts say investors could be hurt if they are overexposed to small companies.
"I am a little nervous about small-caps," said Prudential Equity Group small-cap analyst Steven DeSanctis. "If the U.S. economy slows at all, it will hurt small-caps."
The problem isn't necessarily major economic trouble, but rather the valuation of small-cap stocks at a time of weakening earnings. Since 2003, small-company stocks have become more expensive to buy than large company stocks. That's unusual. And DeSanctis said prices are too high compared with the profits small companies are likely to generate this year.
Currently, the price of Russell 2000 stocks is about 18 times expected 2007 earnings, while the price of larger companies in the Russell 1000 index is about 15 times.
"That was fine when small-cap earnings growth was about 20 percent," DeSanctis said. But he's expecting this quarter's small-company earnings to grow about 6.7 percent year-over-year.
If he's right, small-caps could take a beating. Most analysts are forecasting about 13.3 percent growth, or roughly double DeSanctis' estimate.
Although small caps tend to be more volatile than large stocks, investors seem to be in no mood for caution.
During visits last week with money managers, Leuthold Group analyst Jim Floyd said they were not receptive to warnings about small-caps.
They wanted more small-caps, not fewer, Floyd said. With the Standard & Poor's 600 small-cap index up about 108 percent since the beginning of 2003, and the Standard & Poor's 500 large-company index up about 59 percent, indulging in small companies has been the way money managers have been able to beat the averages.
"The attitude is that small-caps seem to be holding up well, so why not buy them," he said. However, "assuming nothing is going to change hasn't been a good strategy."
Leuthold said small-caps have sold at a discount to large-caps about 54 percent of the time since 1983. Yet, currently, small-caps are selling at about an 11-percent premium.
Floyd said the median small-cap stock would have to decline 28 percent to return to a median valuation. "In a nasty bear market," Floyd said, small- and mid-cap stocks "could be expected to fall about 49 percent."
Floyd isn't predicting that, but concerns about slowing small-company earnings prompted Leuthold to sharply reduce exposure to small-caps. Two years ago, the company had 17.3 percent of its stock portfolio in small-caps. Now, it's down to 3.3 percent.
In the 2006 fourth quarter, the earnings of very small companies -- known as microcaps -- were growing at a 4.2 percent annual rate. That compares to a year earlier, when earnings were growing at 12.4 percent, according to Leuthold analyst Andrew Engel. Meanwhile, the opposite has happened with large-cap stocks. At the end of 2006, earnings were up 17.3 percent. A year earlier, it was 16.1 percent.
Gail MarksJarvis is a columnist for the Chicago Tribune.