Small-Cap Analysts Prove Best as ‘Buys’ Beat Out ‘Sells’ by 12%

Analysts covering the smallest U.S. equities are proving to be the best stock pickers.

Standard & Poor’s SmallCap 600 Index companies with the highest recommendations beat the lowest-rated shares by 12 percentage points in the year ended May 31, according to data compiled by Bloomberg. Over the same period, the S&P 500 shares most favored by analysts trailed the worst-ranked companies by 6.2 percentage points, the data show.

Small-stock analysts are more successful because their recommendations tend to influence trading and the companies are easier to evaluate, according to James Paulsen at Wells Capital Management and Eric Marshall at Hodges Capital Management Inc. S&P SmallCap 600 companies trade less than those in the S&P 500, with daily volume averaging 373,240 shares in the past 30 days versus 5.6 million, Bloomberg data show.

“With small caps, you’re dealing in a universe that’s less followed, more illiquid -- and people move on analyst calls,” said Paulsen, the chief investment strategist at Minneapolis- based Wells, which oversees about $340 billion. “With the large caps, it’s your standard problem of herds and contrarian thinking. By the time you give a good case why you’re recommending a stock, it’s already extended. The smart money’s already leaving.”

When S&P SmallCap 600 stocks followed by six or more analysts are ranked by their average rating on May 29, 2010, companies in the top fifth posted gains of 32 percent during the 12-month period that ended May 31, compared with 20 percent for the bottom fifth. It’s almost the opposite case for larger companies: For S&P 500 equities with 20 or more recommendations, companies with the lowest ratings returned 33 percent versus 27 percent for the highest.

More Expensive

The S&P SmallCap 600, made up of companies with an average market value of $870.3 million, rallied 29.7 percent including dividends in the year ended May 31, beating the S&P 500 by 3.7 percentage points. The index of smaller companies has led the S&P 500, with stocks averaging $24.6 billion in value, in nine of the past 10 years, sending its price-to-earnings ratio to the highest relative to the benchmark measure since 1995.

Large-company analysts have failed to add value throughout the bull market that began in March 2009. Through Dec. 31, the most-favored S&P 500 stocks posted average gains of 73 percent, compared with 165 percent for their least favorite.

‘Incremental Value-Add’

“Once you have a company that has 50 analysts following it and 48 of them are a buy, the story is well known,” said Don Wordell, a fund manager for Atlanta-based RidgeWorth Capital Management, which oversees about $48 billion. “There’s no incremental value-add. It’s not a low expectation story at that point. Small-cap is just a different animal in that there can be something very differentiating about that research.”

For every $1 invested in the S&P SmallCap 600 at the beginning of the five years ended May 31, investors would have made 28 cents, while earning 18 cents for the S&P 500, according to Bloomberg data. While small-cap equities have beaten larger companies in the past decade, they can also underperform during periods of market volatility. When equities bottomed in March 2009, S&P SmallCap 600 had slumped 59 percent in price from its high in 2007, compared with the S&P 500’s slump of 57 percent.

Remote Connections

LogMeIn Inc. (LOGM) was one of the small-cap stocks most- recommended by analysts last May, according to Bloomberg data. The Woburn, Massachusetts-based provider of services to connect remotely to computers has surged 71 percent in the year ended May 31. It has 10 “buy” ratings and no “holds” or “sells.”

Emergent Biosolutions Inc. (EBS) in Rockville, Maryland, was in the top fifth of stocks with the highest ratings. The maker of drugs that fight bioterrorism returned 59 percent and has five “buy” ratings and one “sell.”

Another top-ranked small cap was San Clemente, California- based ICU Medical Inc. (ICUI), a maker of connectors used to administer intravenous drugs, Bloomberg data show. ICU rallied 36 percent in the year ended May 31.

Analysts who cover small-cap equities probably have an advantage because they get more attention from corporate management and cover companies with less-complex business models, according to Wordell and Marshall, who helps oversee about $700 million at Dallas-based Hodges.

“Smaller companies also tend to have fewer moving parts and that may make the predictability of earnings and cash flow a little bit easier,” Marshall said.

Speaking With Analysts

Wordell said executives are inclined to speak with analysts because they publicize the companies in research reports sent to potential investors.

Gregory Wade, a San Francisco-based analyst at Wedbush Securities Inc. who covers biotechnology companies including Emergent, said the Maryland company has a more “predictable” business since the U.S. government provides most of its sales. Emergent said May 26 that the federal government will buy 44.75 million doses of BioThrax, the only anthrax vaccine registered by the Food and Drug Administration, over five years.

“There are very few businesses where you can see five years of visibility into the demand for your product,” said Wade. Executives at smaller companies may be more forthcoming. “The U.S. government is also paying for the expansion of your manufacturing facilities. You’ve got pricing certainty. That’s just really unprecedented,” he said.

Greater Detail

Richard Baldry, a Baltimore-based senior analyst at Signal Hill Capital Group LLC who covers companies that provide Internet-distributed software, said analysts can do more work to understand smaller stocks in greater detail. Baldry joined LogMeIn when executives met with clients, and he hosted management this year at an investor conference.

“If a company only has 500 employees, you can meet five or 10 percent of their employees and get a much better picture,” he said. “If a company has 10,000 employees, then the sample of information you’re getting is very small. Management teams are more accessible in the small-cap world.”

To contact the reporters on this story: Inyoung Hwang in New York at ihwang7@bloomberg.net; Fred Jespersen in New York at fjespersen@bloomberg.net

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Laurie Meisler at lmeisler@bloomberg.net

Bloomberg reserves the right to edit or remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.