Even In Small Caps, It's A Tech Rally

The small-stocks surge is real, but its scope remains narrow

For the past five years some of Wall Street's top small-cap pundits doggedly predicted that small stocks would outperform large stocks. It finally happened last year. With a sudden burst in December, the Russell 2000 index--the most widely used gauge of small-stock performance--slipped past the Standard & Poor's 500-stock index. This year the Russell is on a tear again. It's up 14.5% through Feb. 29, vs. a 7% decline in the S&P 500.

Some investors are saying that small-cap stocks are finally ending their painful slump. "The market is realizing large-cap valuations are extremely high, and a natural broadening out is occurring," says Joseph Gatz, manager of Loomis Sayles Small Cap Value Fund.

But does the small-cap resurgence really signal a broadening of the market? The answer appears to be no. As in the overall market, tech stocks and biotech stocks account for nearly all the gains in the Russell 2000, while nearly all others are lagging behind (table, page 138). So far this year, only 56 stocks accounted for the Russell 2000's gain through Feb. 28. Nearly all were high-flying tech names with the biggest winners PE Corp. Celera Genomics Group, up 229%, and Human Genome Sciences Inc., up 187% year-to-date, says Steven G. DeSanctis, small-cap strategist at Prudential Securities Inc.

The two-tier small-cap market has left value investors out in the cold again. Through the end of February, 190 small-cap value funds tracked by Morningstar are up an average of just .04%, while 342 small-cap growth funds, which invest heavily in technology, are up 22.7%.

Pressure on small-cap value investors is likely to continue. Mutual fund investors chasing high returns are concentrating their bets ever more heavily on technology. So for this year, more than half of the $65 billion going into U.S. equity funds has gone into technology, biotech, and aggressive growth funds, according to AMG Data Services.

Some small-cap managers are worried. Gatz's value fund aims to avoid buying stocks that trade above the Russell 2000 average price-earnings ratio of 21, so he's limited in the number of tech and biotech names he can buy. Now that the Russell is soaring, Gatz groans, "It's like finally getting an invitation to a big party, and you get stuck in the parking lot."

Small technology stocks are soaring because profit expectations in the sector are sky-high. Consensus Wall Street analyst earnings' estimates for small-cap-tech stocks this year call for astounding profit growth of 151%, says Chuck Hill, director of research at First Call Corp. By contrast, consensus estimates of profits for the large-cap tech stocks in the S&P 500 are just 29%, Hill says.

True, small-cap stocks have staged brief rallies repeatedly in the last five years, only to disappoint. But this time might be different. For the last few years investors have focused on the advantages of large stocks compared to small stocks, says Paul Antico, manager of Fidelity's Small Cap fund. "That's not the case any more--now it's tech vs. nontech" regardless of a company's size, he says.

Technology's might is zapping the appeal of classic defensive stocks that investors tend to favor when the economy weakens, as many now fear will happen as Fed Chairman Greenspan raises rates. Consumer staples, including companies whose profits typically hold up well in recessions, such as Smithfield Foods Inc. and Coca-Cola Bottling Co., are down 9.7% this year.

BETTING ON THE "BARBELL." Even non-tech industries with strong earnings prospects are sucking wind. DeSanctis estimates small-cap energy stock profits will rise 42% this year, but the sector is so far eking out just a 9% gain. "Everybody's going after high-growth companies and ignoring everything else," DeSanctis says.

Still, some small-cap specialists anticipate strength in the broader small-cap market. Satya Pradhuman, of Merrill Lynch & Co., is betting on a "barbell" effect, in which both the top and the bottom sectors of the small-cap universe see healthy gains this year. His reasoning? Pradhuman says 21% of the small-cap stocks he tracks are trading at rock-bottom valuations of less than 10 times earnings tracked over the year to date. And the bottom stocks will get a boost because many of them will be takeover or merger targets, he says.

Pradhuman's bottom line: the Russell 2000 will be up about 14% at yearend--vs. a 10% rise in the S&P 500, according to market forecasters polled by BUSINESS WEEK at the end of last year.

Pradhuman's forecast may turn out to be on the mark. Not because the market will broaden, but because small-cap tech will continue to skyrocket.

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