`The Muscle Is In The Russell'

Small caps could beat the S&P 500 for the first time since 1993

Small is big on Wall Street these days. After more than a year of languishing while investors were captivated by the blue chips, the stocks of small companies are finally leading the way.

Over the past five weeks, the Russell 2000 index, the most commonly followed measure of small-capitalization stocks, has gained nearly 4%, while the Dow Jones industrial average slipped 6.5% and the Standard & Poor's 500-stock index fell 4.3%. "The bull market has new leadership, and it's secondary stocks," says Ralph J. Acampora, the top technical analyst for Prudential Securities Inc. "The muscle is in the Russell."

CATALYST. And small caps are not likely to go flabby anytime soon. Market forecasters say these stocks should outperform the large caps through the end of the year, and possibly into 1998. That means small caps could best the S&P 500 this year for the first time since 1993. Through Sept. 10, the Russell 2000 is up 20.5%, the S&P 500, 24.1%.

On its face, the move to small-cap stocks comes from disillusionment with the large caps. Statements from key big-cap companies such as Coca-Cola Co. and Gillette Co. that earnings would not be quite up to expectations in the second half led to the move, says Claudia E. Mott, Prudential Securities' director of small-cap research. That prompted investors to cash in some profits and look for other opportunities.

The newfound affection for smaller companies is built on sturdy fundamentals: higher forecasted earnings and lower price-earnings ratios. The estimated earnings growth for the next 12 months is 23% for the Russell 2000 companies vs. 14.7% for the S&P 500, according to First Call Corp. The p-e ratio based on expected earnings for the small caps is 12, vs. 18 for the S&P 500. Even investors who like dividend-paying stocks have discovered they aren't giving up much to buy smaller companies, says Frank H. Reichel III, who runs the Stratton Small-Cap Yield Fund. The yield on the Russell 2000 is 1.2%, vs. 1.6% for the S&P 500.

The small-cap rally may owe something to Washington. Peter J. Canelo, a market strategist at Morgan Stanley, Dean Witter, Discover & Co., says small stocks started to soar as soon as the President and Congress reached a deal on the capital-gains tax cut--"one better than we ever hoped for." That deal slices the maximum tax rate on long-term capital gains from today's 28% to 20%--and 18% in five years. "These companies are fast growers, pay little or no dividends, and so they're very sensitive to changes in capital-gains taxes," says Canelo, adding that stronger economic growth also gave investors confidence to invest in these smaller, somewhat riskier companies.

Small-stock analysts and portfolio managers have long awaited this flip-flop in the relative performance of large- and small-cap stocks. Now they're crossing their fingers it's for real. "It's been a humbling experience," sighs Satya Pradhuman, a quantitative analyst who follows the stocks of small companies for Merrill Lynch & Co. "Since the beginning of the year, a number of critical indicators have suggested small caps were undervalued, but that didn't seem to make any difference."

The last time the Russell 2000 had the upper hand was in early 1996. All stocks plunged in July of that year, but as the markets rebounded, investors favored large caps. For all of 1996, the Russell 2000 lagged the S&P 500 return by 6.4 percentage points. Small stocks sank again from February through April of this year--especially the high p-e tech issues. Small stocks scored a sharp 11% gain in May but could not gather enough momentum to outrun the blue chips. "The S&P was throwing a great party and no one wanted to leave," says Louis Navellier of Navellier & Associates, a fund manager and newsletter publisher.

If the smaller stocks retain their market leadership, it will also be good news for mutual-fund investors. As strong as fund results have been for the last few years, they haven't been as good as the S&P 500. That's because most funds on average invest in companies smaller than those in the S&P, and they usually invest in them equally rather than according to company size.

No one is more pleased to see the surge in the smaller stocks than some of the fund managers who specialize in small-cap growth stocks, the hardest hit. "It's been tough," says Gary L. Pilgrim, portfolio manager of the $6 billion PBHG Growth Fund. "We're up 35% from the low in April, but our performance is barely positive for the year." As the accompanying table shows, the average small-cap growth fund is up 38.3% since late April, but only 17.7% year to date (though the best of the lot more than double that). Those funds invest heavily in the volatile high-tech, health-care, and retail sectors. Russell 2000 tech stocks are up 53.7% since late April but only 18.7% for the year. Small-cap value funds, which invest in more mundane financial and industrial companies, have gained less since the April bottom but are beating growth funds so far this year.

For sure, the investors will be hearing a lot more about the Russell 2000 in coming months. The "Russell" part of the name comes from Tacoma (Wash.)-based Frank Russell Co., one of the world's leading investment- management consulting firms. Russell created stock indexes a decade ago by ranking the 3,000-largest U.S. stocks by market capitalization. The 1,000 largest became the Russell 1000, and the back two-thirds, the Russell 2000. The two together make up the Russell 3000.

Institutional investors and market analysts have increasingly turned to the Russell 2000 as a measure of the small-cap market as the NASDAQ Composite, the principal over-the-counter market index, has become increasingly influenced by large-cap high-tech stocks such as Microsoft Corp. and Intel Corp. The median market cap of a stock in the Russell 2000 is $450 million, less than one-tenth that of the S&P 500. Many investors equate small-cap and high-tech, but technology accounts for only 13.4% of the Russell 2000. Financial firms, the largest segment, make up 23.3% of the index.

NARROWER SPREADS. As the small-cap stocks gained strength in recent weeks, money has started to roll in. "Fund investors are clearly rotating from large-cap to small," says Robert Adler of AMG Data Services. His data show that in the week ending Sept. 3, equity funds took in about $5.3 billion in new cash, about 40% of which went to funds that invest in small-cap stocks. Year to date, such funds have taken in only about 20% of new cash. There's not yet a lot of new money from institutional investors. In the first six months of 1997, small-cap managers accounted for about 26% of all new money placed, according to Eager & Associates, a Louisville investment- consulting firm. In 1993, a strong year for small-cap investing, that figure was 33%.

Of course, a little money goes a long way in moving these stocks. The market value of the entire Russell 2000 is a little more than $1 trillion--about the same as the combined value of the six-largest stocks in the S&P 500. Some small-cap pros also believe structural changes in the over-the-counter market are having an effect on prices as well. Regulators have begun ordering market makers to trade the stocks with narrower spreads--in increments of sixteenths instead of eighths. The result is fewer market makers in many stocks, with remaining dealers keeping fewer shares in inventory. "That hurt on the decline," says Navellier, but he admits that it is boosting prices as demand picks up.

What could spoil this sweet scenario? A flood of bad initial public offerings, says fund manager Garrett R. Van Wagoner. He says investment bankers "are trying to bring out garbage they couldn't shovel out in the spring or summer." A few costly flops could send the whole sector into a swoon. The other danger, says Canelo, is a sharp increase in interest rates. But in that unlikely case, the large-cap stocks will get crushed as well.

William R. Keithler, who runs two Berger small-cap mutual funds, thinks that these stocks will continue to rally, but he says that this probably isn't the start of a huge upward move. Stocks of small companies, he notes, make their greatest gains coming out of a recession. That was the case in 1991, when the Russell 2000 logged a 44% return, but it's not the case now. "We've got a lot of ground to make up," he says. Still, making up that ground can make investors a lot of money.

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