It May Not Be Taps For Small Caps

For fans of small-cap stocks, who had counted on seeing those little devils continue to beat the market, 1994 is not going according to plan. Secondary stocks have joined their larger brethren in a seesaw move that has brought them back to just below where they started at the beginning of the year (chart). It seems that the resurgence in small-cap stocks is grinding to a halt.

Or is it? In fact, the small caps are probably hesitating, not conking out. Valuation levels remain reasonable--secondary stocks are trading at a historically favorable 25% premium to the price-earnings ratio of the Standard & Poor's 500-stock index. And although some sectors are likely to come in for continued potshots, as evidenced by the troubles that have beset once high-flying sectors such as health care and casinos, the economic winds are actually blowing the small caps forward. John W. Ballen, who runs small-cap portfolios for Massachusetts Financial Services, observes that "even though earnings growth in the S&P 500 may be difficult to come by, because of margin squeezes and resistance to raising prices, companies with high unit growth will be rewarded." And to him, that argues in favor of the small-cap sector.

HOTBEDS OF HYPE. There is another argument for small-cap stocks, at least according to portfolio managers like Ballen: They are not performing quite as poorly as they often do during times of market setbacks. The whipsawing volatility of previous corrections simply isn't there for the most part, even though money-flow statistics show a steady stream of investment funds out of over-the-counter stocks into the components of the S&P 500.

The market's blase attitude toward secondaries may be a reflection of the sentiment among small-cap stock pickers, who tend to be "bottoms-up" types who hunt companies on the basis of fundamental factors, pretty much ignoring Street sentiment. "We agree with Warren Buffett--long-term investing is his style too," says Lee Kopp, whose Kopp Investment Advisors money management firm runs $1 billion in small- and mid-cap portfolios. That's a pretty typical, if self-serving, sentiment among professional small-cap investors, most of whom have seen their holdings flat or down in the year to date.

If there is danger in the small-cap arena, it resides among the hotbeds of hype. Among them are cold-caller favorites such as recent initial public offerings and fads such as restaurant chains and casinos--though gambling companies have been so battered that they may be a good buy now. The best approach to small caps--which plays off their major advantage over large stocks--is to focus on the many sound companies that are not widely followed by brokerage-house analysts. They are not necessarily obscure companies. Marina Carlson, co-manager of the Strong Common Stock and Opportunity mutual funds, counts among her favorites Libbey Inc.--a glassware company with a well-known name in Middle America. "It's a very cheap stock, selling at just 10 times projected 1994 earnings," Carlson notes.

NICHE BY NICHE. Another area where opportunities abound is health care. Kopp is cherry-picking smaller companies such as Hillhaven Corp., a leading national nursing home chain, while avoiding ethical-drug makers and health-maintenance organizations that are becoming, he feels, a bit pricey. At the Delaware mutual fund group, small-cap portfolio manager Edward Antoian is also looking for niches within health care. Health care for women, for example, is the focus of companies such as Columbia Laboratories, Noven Pharmaceuticals, and Ethical Holdings.

With "niche investing" all the rage among small-cap buyers, that means concentrating on sectors that are little-known to most investors. Home-security companies, for example, are a potentially high-growth area that Antoian is pursuing. Fear of crime, he notes, is giving a boost to such residential-security outfits as Pittston Services, ADT, and Multimedia. That's small solace for anyone who has been burglarized lately. But finding silver linings in clouds is what small-cap investing is all about nowadays.

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