Small-cap stocks have had an incredible run through the most recent bear and bull markets. The Russell 2000 index, the popular proxy for the small-cap market, has gained 42.7% since April, 1999, compared with a 12.2% loss for the Standard & Poor's 500-stock index (MHP ).
But after an unprecedented 63 months of stellar performance, small-cap stocks are not the screaming buys they once were. Compared with large caps, the valuations are roughly the same. Small caps are cheaper on price-to-book value and price-to-sales but slightly more expensive when measured by price-earnings ratio or expected earnings growth.
Still, it's not time to bail out of small caps. "With the economy expanding, you can still get more bang for your buck in small caps," says Andrew Engel, a senior research analyst at the Leuthold Group. Unlike last year, however, when small caps rose across the board -- even those with large debt loads or spotty earnings prospects -- the market today requires investors to be more selective. "It's better to be proven than unproven," says Harvey H. Bundy III, co-manager of the new $13.5 million William Blair Small-Mid Cap Growth Fund. "Earnings are better than no earnings."
Small companies typically operate in niche markets and have just one core business, so "when things are good, they are very good," says Lawrence R. Creatura, manager of the $525 million Constellation Clover Small Cap Value Fund (TCSVX ). What's making things very good for some smaller companies is their ability to raise prices.
Pricing power is giving a big boost to small caps in travel and lodging, for example. While apartment and office properties continued to be built during the slowdown, hotel construction remained flat after the World Trade Center was attacked. Now that travel is picking up, "there's no new supply of hotel rooms," Creatura says. "It's the worst shortfall we've seen in decades." That has allowed some operators to hike room rates. Among Creatura's investments are FelCor Lodging Trust (FCH ), a real estate investment trust that operates Embassy Suites, Crowne Plaza, and Doubletree hotels in popular destinations including California and Florida.
Selected media concerns have gained pricing power, too. That's why William C. McVail, lead manager of the $250 million Turner Small Cap Growth Fund (TSCEX ), favors Atlanta radio station operator Cumulus Media Inc. (CMLS ), which owns and operates more than 250 AM and FM stations in small and midsize markets throughout the U.S. With increased demand for ad spots during the prime drive-time hours, Cumulus recently raised rates.
Consumer spending remains strong, so retailing presents some opportunities. Certain retailers are attractive not only because they are raising apparel prices but also because they've improved technology to better manage inventories and perk up profits. Robert Male, co-manager of the $1.6 billion Buffalo Small Cap fund (BUFSX ), has invested in J. Jill Group (JILL ), which is popular with affluent baby boomers. The Quincy (Mass.) clothing retailer has successfully used technology to overhaul the products in its catalogs and more than 125 stand-alone stores. After realizing its muted color palette was too narrow, for example, J. Jill quickly copied popular fashion styles in brighter colors, attracting new customers.
One of the best reasons to hunt for small-company stocks on your own is that Wall Street doesn't cover them very well. Cutbacks in equity research have left even more of these stocks in the shadows. Find the smaller companies with the ability to grow and work their way onto Wall Street's buy lists. That way, when the deep-pocketed institutional investors get interested, you already own them.
By Lauren Young