Small Caps: Out Of The Tunnel?

Two years ago, small-capitalization stocks were the darlings of investors. Last year, they stalled, and now they're trailing the pack. The group has suffered in 1995, as skittish buyers moved to the comfort of familiar blue-chip names and as the weak dollar aided larger companies with foreign revenues. Accordingly, such measures as the Russell 2000 Small Stock Index have badly underperformed the Standard & Poor's 500-stock index.

Just weeks ago, prospects for an imminent turnaround appeared unlikely, analysts said. But now, the slowing economy gives small-cap investors cause for optimism. Claudia Mott of Prudential Securities notes that small caps, which began underperforming large companies in February, 1994, are likely to outpace them once the economy stalls. The reason: Although small companies are typically hurt early in a downturn, their earnings bounce back faster, since they can respond more quickly to the business cycle than their big brothers.

"DAMN NERVOUS." Falling interest rates should also help small companies, which tend to do relatively more short-term borrowing than large ones. And the possibility of a cut in capital-gains tax could entice investors toward small companies, because they generally pay little or no dividends. So far, however, these glimmers of hope haven't been enough to set the sector afire. "Pretty universally, people are damn nervous about investing in small-company stocks," says Michael P. DiCarlo, a portfolio manager at John Hancock Funds in Boston. But for value investors such as DiCarlo, this bad news is actually good news. Noting that on a price-to-book-value basis, small-cap stocks are cheaper than they've been since 1990, bargain hunters are finding lots to buy.

Technology is the small-cap sector DiCarlo likes best. Dismissing fears that the Russell small-cap technology group, up 13.8% in the first five months of 1995, may be overblown, he says the boom could last till the end of the decade. He particularly likes America Online Inc. Buying shares of AOL, he says, is "like investing in television in the 1940s." (AOL and BUSINESS WEEK are partners in a venture that gives AOL subscribers electronic access to the magazine.) Atmel Corp. and Adaptec Inc. are among his other favorites. Atmel makes integrated circuits, and Adaptec manufactures devices that allow computers to communicate with peripheral equipment.

Energy is another appealing small-cap sector. Greater demand for fossil fuels and industry consolidation are fueling the interest of investors such as Michael A. Berry, managing director of Dreman Value Management and an adviser to its Dreman Small Cap Value Fund. Berry especially likes KCS Energy Inc., an Edison (N.J.) oil-and-gas outfit whose shares have been depressed because of a lawsuit filed by Tenneco Inc. over a 1979 contract. "People overreacted and pushed the price down," says Berry, who thinks that KCS, whose stock is now trading at 183/4, will ultimately prevail in the dispute.

Money managers are also paying more attention lately to company location. According to Merrill Lynch & Co.'s Satya D. Pradhuman, the prospects of smaller companies generally are tied more closely to their regional economies than those of bigger ones. That has proved to be good news for companies in such economically robust areas as the Southeast and the Great Lakes.

EXPORT OPENING. A strong Midwestern economy has boosted First American Regional Equity Fund by 18% in the first five months of this year. Richard J. Rinkoff, who manages the fund, likes Aetrium Inc. in North St. Paul, Minn., a maker of testing devices for the semiconductor industry that boasts a 20% aftertax profit margin. Another top choice is Automotive Industries Holding, a nonunion manufacturer of plastic parts for car interiors. Headquartered in Minneapolis, the company enjoyed a 47% surge in sales last year.

While most small caps are planted firmly in U.S. markets, there are some with enough overseas business to benefit from the anemic dollar. Mike Berry's Dreman fund owns shares in Sofamor Danek Group Inc., a Memphis health-care company he says controls 42% of the worldwide market for spinal implant devices. The fund also holds stock in Mercer International Inc., which buys assets from the former East German government and turns them around using Western technology and management.

Over time, small companies clearly outperform their larger brethren, but "you have to be an investor as opposed to a trader," warns Ron Baron, a New York money manager. If past performance is any indication, small-cap investors should get their just rewards soon.

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