It's A Mid, Mid, Mid Market

Mid- and small-cap stocks are beating large-caps as investors look for earnings

The old saying that good things come in small packages may be true for diamonds and gold coins, but it hasn't exactly applied to the stock market over the past few years, with large-cap stocks taking center stage. But now small-cap stocks--and, even more, mid-caps--are starting to steal the show.

The Standard & Poor's 400 Mid-Cap Index is up a brisk 21% so far this year, and the S&P 600 Small-Cap Index is up 12%, easily besting the Standard & Poor's 500-stock index, which is up just 1.1%, and the Nasdaq Composite Index, down 4.3%. True, small-caps did O.K. last year, with the S&P 600 Small-Cap Index up 11%. But this year they are doing even better, leading some to believe that 2000 will see a breakout--and another year or more of outperforming the overall stock market.

What has caused this flight down the food chain? "Investors are really hungry for growth right now, and there is relative undervaluation of small-caps vs. large-caps," says David Riedel, an emerging-growth stock analyst at Salomon Smith Barney. And as investors are more preoccupied with growth, they are less concerned with liquidity. "When folks get enthusiastic about these stocks, you see quite a run," adds Riedel. Indeed, growth in large-caps has trailed off, due mostly to rising interest rates and a slowing economy. And small- and mid-cap stocks, though also affected by rising rates, have more rapid growth, so they are not as affected by additional interest-rate expense.

LESS RISKY. Earnings for the S&P 600 Small-Cap Index and the S&P 400 Mid-Cap Index are expected to grow 18% and 16% respectively on an annual basis over the next five years, according to First Call, the earnings research company. That's versus 14% annually for the S&P 500. They're relatively cheap, too. The S&P small-cap index and the S&P mid-cap index are trading at 18 and 19 times forward earnings, respectively, vs. 25 times for the S&P 500.

In fact, mid-caps, which typically have a market capitalization between $2 billion to $10 billion, are beating out small-caps. One reason: Mid-cap stocks are perceived by investors to be less risky because they have more of a track record and proven earnings. "The market now loves earnings, so mid-caps are easier to stomach," says Satya Pradhuman, director of small-cap research at Merrill Lynch & Co. He also points out that mid-cap stocks have easier access to capital than small-caps, thus greater ability to make their businesses grow.

The sectors that are performing the best in both mid- and small-caps--technology, energy, financials, and healthcare--are also the ones with the strongest earnings. Overall profits at technology and energy companies, including large-cap companies, are expected to be up 51% and 112%, respectively, this year. Health-care earnings are expected to be up an eye-popping 300%, due to the remarkable growth of biotechs and easy comparisons to last year's relatively weak earnings.

"EARNINGS BOOM." Among stocks with good earnings prospects, Pradhuman especially favors health-care companies like Quorum Health Group Inc. and Universal Health Services Inc. In tech, Salomon Smith Barney's Riedel likes some of the semiconductor capital equipment outfits such as Credence Systems Corp. and LAM Research Corp. He also favors energy companies like Andarko Petroleum and Ocean Energy Inc.

Overall, mid- and small-cap earnings look rosy for the rest of the year, too. S&P 400 Mid-Cap and S&P 600 Small-Cap earnings are expected to be up 31% and 35%, respectively, over last year. By comparison, the earnings for the S&P 500 are poised to grow only 18% by yearend. "There's a huge earnings boom going on in these companies. They're capitalizing on an economy that despite its slowing, is still strong. And the growth opportunities are much more evident than with larger companies," says Joseph Kalinowski, equity strategist at I/B/E/S. Indeed, since 1998, mid-caps have averaged around 16% annualized growth, vs. 5% for small-caps, largely due to profitless dot-coms.

VALUATION DISPARITIES. It's not just growth issues that are giving mid- and small-cap indexes a boost. Value stocks are looking up, too. The Russell 2000 Value Index is up 16% for the year vs. the Russell 2000 Growth Index, which is in slight negative territory, also due to those aforementioned dot-coms. But another reason is the amount of corporate activity taking place among small value stocks. "You've had such huge valuation disparities between large and smaller stocks, we're seeing a much more aggressive amount of merger and acquisition activity," says Merrill's Pradhuman. He points out that the acquisition premiums of small value companies have been rising. In the first quarter of this year, small companies were bought out at an average of 30% over their stock price--the highest premium since 1992. And with premiums falling back to 24% in the second quarter, still the highest in five years, such stocks remain a buyers' market. "That alone should prolong the small-cap story," says Pradhuman.

Others, like Michelle Clayman, chief investment officer of money management firm New Amsterdam Partners, are buying smaller value stocks because they're so cheap. "These are good companies that have either not participated or gotten beaten down," she says, adding that some even look like bonds because they pay dividends. Some picks: furniture company Leggett & Platt, homebuilder and financial services company Pulte Corp., and brokerage A.G. Edwards. "You've got to expect them to stage a comeback," she says.

In recent years that sort of prediction has repeatedly fallen short of expectations, with the overall gains of small stocks returning to being pretty small. But if she's right and smaller value stocks start booming too, that could ignite a small- and mid-cap explosion that goes well beyond 2000.