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Jewish World Review August 14, 2007 / 30 Menachem-Av, 5767 Small stocks are coming with large caveats By Gail Marks Jarvis
http://www.JewishWorldReview.com | (MCT) For two years, market watchers have been nagging investors to be careful about overdosing on small-company stocks and to stop shunning large companies. But those who listened regretted it, as the smaller stocks continued to outperform - until recently. Now small caps are lagging, and some experts say it could get much worse. As fear took hold of investors recently amid signs of a potential credit crunch and worsening housing recession, investors turned away from the most fragile companies, and small-cap mutual funds became fund investors' biggest losers. The "value" variety, or those considered cheaper stocks that may be on shakier ground financially, has been treated the most harshly. Since the market peaked July 19, investors in small-cap value funds have lost an average of about 10 percent, according to Lipper Inc., which tracks mutual fund performance. While U.S. stocks of every size took a beating in July, the smallest of the small stocks felt it the most. The Russell Microcap Value Index dropped 8.2 percent in the month, continuing a trend that began a few months ago. These very small company stocks have declined about 5.2 percent for the year. Meanwhile, large, fast-growing companies fell only about 1.5 percent in July, and they are still up about 6.5 percent for the year. Russell Investment Group strategist Steve Wood said he believes large companies have been the most resilient because "there was some valuation attractiveness in this segment." In other words, a five-year small-cap craze has left the smaller-company stocks significantly more expensive than large companies like Microsoft Corp., General Electric Co. and Wal-Mart Stores Inc. Analysts say the more reasonable stock prices, combined with the substantial amount of business that large U.S. companies do in strong overseas markets, will continue to help larger companies. Small companies can have trouble when the economy slows. They tend to be more dependent on U.S. customers, compared with larger companies. Among the large companies that make up the Standard & Poor's 500 index, 27.9 percent of total sales come from outside the U.S. The small companies that make up the S&P 600 index derive only 15.9 percent of sales in international markets, according to Citigroup strategist Lori Calvasina. "Stocks with the highest international sales exposure have experienced significantly better average performance in recent months," she said. And mid-size companies with the highest international sales exposure have had an advantage over small stocks doing a lot of business overseas. Mid-size stocks derive 22.3 percent of their sales overseas and have been popular targets in the leverage buyout boom. Besides their domestic focus, small companies tend to be more vulnerable than larger companies when the tap for loans is turned down, as it has been amid a recent lending scare set off by home mortgage losses. If companies can't borrow money at affordable rates, they may have to curtail business activities. But larger companies often have greater resources to fall back on than smaller companies. A recent survey of small businesses by the National Federation of Independent Business shows reason for concern. Optimism levels among small-business owners were measured near a four-year low. The business owners were concerned about slumping sales and constraints on their ability to raise prices adequately to cover their costs. Since 2005, small and very small companies, the microcaps, have had their profits fade. The trend is especially pronounced as second-quarter earnings are being reported, said the Leuthold Group in a recent report. The median profit gain among the largest 300 companies has been 16.9 percent. But the smallest 600 companies have had a slight decline - 0.9 percent, according to Leuthold's tally. The market's larger small companies have had a median earnings gain of 2.4 percent. As corporate sales have slowed, small companies have felt tighter conditions more than large companies. In 2006, small companies enjoyed strong sales momentum - 14 percent gains in that year's second quarter, compared with 13 percent for large companies. But recently, the median large company has had an 11 percent gain, compared to only about 9 percent for small companies, according to Leuthold research. "A jittery stock market, credit tightening, slower U.S. economy and lowered appetite for risk are all factors which point toward large-cap leadership," Leuthold analyst Jim Floyd said. And besides the treacherous conditions ahead for small caps, the stocks are expensive, Floyd said. Typically, small stocks sell at prices lower than larger companies, but they now sell at a 7 percent premium. While small caps have fallen lately, it could become much worse. To return to median valuation levels that have existed since 1983, the stocks could go down 25 percent, according to Leuthold's Andrew Engel. His research shows large companies aren't cheap either, but they are not as expensive as smaller ones. To return to median levels, large stocks would have to fall about 8 percent. Every weekday JewishWorldReview.com publishes what many in the media and Washington consider "must-reading". Sign up for the daily JWR update. It's free. Just click here. Gail Marks Jarvis is a personal finance columnist for the Chicago Tribune and author of "Saving for Retirement without Living Like a Pauper or Winning the Lottery." Comment by clicking here.
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