Little Things Could Mean A Lot Again For Small Caps

It's hard to be disappointed by the stock market when it breaks records steadily all year. But for investors in small-capitalization stocks, there was reason to feel a bit shortchanged. In 1995, while the Standard & Poor's 500-stock index turned in a 37% total return, the Russell 2000 delivered 26%. Despite starting the year strong, small-caps stalled in September, just before the market exploded. So much for the old saw that small-cap stocks usually outperform big stocks because they tend to be faster-growing companies.

But small-cap pros think the market tide may finally turn in 1996. The biggest big-cap winners this year were large high-tech and consumer stocks, which led a spectacular increase of 18% in the earnings of companies in the S&P 500 index, while Russell 2000 companies' earnings were up 16.5%. Large companies will be hard-pressed to maintain that momentum in 1996, says John W. Ballen, who manages $3.7 billion in small- and midcap portfolios for Massachusetts Financial Services Co. Ballen believes small-cap earnings will outperform large-cap earnings next year.

Another reason to favor small-caps is low interest rates. "Investors have little reason to stash money in low-yielding savings accounts or CDs," says Roland W. Gillis, lead manager for Putnam's $8.8 billion Voyager fund. "Investors are going to wake up and realize that the days of high yields are over and they're going to start paying up for equities," Gillis predicts, adding that small growth stocks will be big beneficiaries. Low interest rates will also boost earnings at small companies, which tend to benefit more from lower rates than large companies because it's easier for them to borrow, says Joel C. Tillinghast, manager of Fidelity Investment Co.'s $3.2 billion Low-Priced Stock fund.

But a bit of caution is in order. "The [small-cap] market may start off the year on shaky ground," says Claudia E. Mott, a quantitative analyst and small-cap guru at Prudential Securities Inc. One warning sign: The price-earnings ratio of the Russell 2000 is 32.5% higher than its 16-year average, and not far below peaks in 1982 and 1993, when the small-cap market had big corrections. Mott is also concerned about the prospect of lower capital-gains taxes being passed by Congress early next year. Both times that Congress lowered capital gains in the past--in 1978 and 1981--small-cap stocks tanked at least 17% in the first three months after the change, as investors locked in higher profits on stock sales.

Still, small-cap specialists tend to be bottoms-up stock-pickers, and they see strong company fundamentals ahead. The biggest small-cap winners this year were growth stocks, and that's where the action is expected to be in 1996. Tillinghast, a top Fidelity stock-picker, likes a mix of finance and technology. In financials, his favorites are First Bank of Puerto Rico, Commerce Group, and United Insurance. In the technology area, his picks include semiconductor industry suppliers Cohu Inc. and BTU International Inc.

IPO HYPE. Gillis, another growth-stock disciple, sees healthy prospects in other sectors, including health care and retail. He likes medical equipment companies Endosonics, Boston Scientific, and UroMed. In retail, he's wary of most discount stores and restaurant chains, but he likes Bed, Bath & Beyond Inc.

Another approach to small-cap investing is to avoid "hot money" sectors such as high tech and focus on special situations. Many managers aren't yet ruling out initial public offerings--one of the hottest parts of the small-cap market--and anticipate more big winners early next year. But the hype is getting thick, and "it's definitely starting to look more risky," says Tillinghast.

Wayne J. Archambo, a small-cap specialist with Boston Partners Asset Management LP, which manages $5 billion in institutional assets, says he avoids IPOs altogether. He's moving money into more stable ground, such as retailing and industrial companies. He likes diaper maker Paragon Trade Brands Inc., which he thinks will benefit from softening pulp prices and a price increase from competitor Procter & Gamble Co. Archambo's picks include Granite Construction Inc., which he expects to benefit from an upcoming referendum among California voters to repair roads and bridges.

Companies such as Granite are typical of the "niche" approach often used by small-cap investors, and that will be an important theme in the next year. With big company profits expected to slow markedly, 1996 may prove to be the year of the small-cap.

Before it's here, it's on the Bloomberg Terminal.