Once Again, Small Is Beautiful

The Russell 2000's new faces are drawing plenty of attention as small-caps, particularly value stocks, continue to post tidy gains

Every summer, fund managers sift through a heap of research on the annual rebalance of the Russell 2000 -- the benchmark index of small-cap stocks -- in which new companies are added and others are dropped for various reasons. Investors scurry to anticipate the changes because they know that being added can send a company's shares soaring, since they'll suddenly be purchased by all index funds that model the Russell 2000.

As the stock market gyrates amid economic uncertainty, interest in the annual rebalance has been at a fever pitch. Merrill Lynch small-cap analyst Satya Pradhuman says, "I've been getting calls since March." The preliminary list is already out, with the the final rejiggered index debuting on July 1.

The intensified scramble is part of a broad renewal of investor interest in small-cap stocks, which typically have a market capitalization of around $750 million. Last year, the Standard & Poor's 500 index of large-cap companies lost a painful 10%, and the Russell 2000 slumped 3.02%. So small-caps, long shunned for their lack of liquidity, are looking attractive as big-cap leaders of the stock market boom lose their luster.


  But small-caps aren't all the same. So far this year, small-cap value stocks have been one of the hottest investments around, gaining 8.4% through May 31, while growth has added just 3.3% in the same period. The Russell 2000 Value index includes companies with lower price-to-book ratios and lower growth forecasts than small-cap growth stocks.

In 2000, the value stocks of the Russell 2000 index posted a 22.83% gain, while its growth counterparts gave up 22.43%. The question, of course, is whether small-cap value stocks will keep rising. Many analysts say yes, but volatility even in this sector is more intense than usual.

The Russell 2000 comprises the 2,000 biggest U.S. companies by market cap that aren't big enough to make the top 1,000. It's revised to flush out the companies that have grown too big to be included or have been edged out by other companies. This time around, some 607 companies will be added to the Russell 2000, and about 429 will be dropped, with tech companies accounting for a big chunk of the additions.

Broad losses in market cap at tech companies will send a slew of them into the small-cap index, driving the index's tech weighting up 6 percentage points, to 16%. Amar Reddy, small-cap analyst at Morgan Stanley Dean Witter, predicts the proportion of growth to value will also make the index more temperamental. That's because the weighting of growth stocks in the index will be 50%, compared to 44% last year.

What's the best way to play these changes? One obvious way is through mutual funds. Lately, small-cap value funds have been the best performers among all categories, up about 13% on average year-to-date, according to Morningstar, which tracks mutual-fund performance. Morningstar's research shows the hottest funds in the class this year are Dreyfus Small Company Value, which is up a stellar 38% year-to-date, and Boston Partners Small-Cap Value, up 37%.


  What sorts of companies will do best among the small-cap value plays? Elizabeth Pearce, portfolio manager at High Mark Small-Cap Value Funds, points to food stocks, noting that smaller brands tend to be undervalued and get better growth while maintaining the defensive characteristics that typically come with investing in food companies. "The value side tends to be more cyclical," she says. "You get a stronger kick as the economy improves."

Hain Celestial Group (HAIN ) is her favorite food stock. Shares have been hovering around $25, down from $40 after Hain's merger with Celestial Seasonings last spring. Pearce estimates that the stock, which trades at two times book value is a bargain and prospects for the company should improve over the next six months.

Rick Giesen, who manages Munder's family of small-cap value funds, likes energy companies. "I think natural-gas companies will do well on a cyclical basis," he says. "Supply is probably the tightest it has been in 15 years." Giesen says that small-cap energy stocks are cheap trading around 4 times 2001 cash flow estimates.

The building-materials sector looks promising to Allen Klee, fund manager at Guardian Park Avenue Fund. At around $8, U.S. Concrete (RMIX ) is trading at seven times next year's earnings per share and looks cheap given the company's long-term growth rate of 12.3%. It's also cheap when judged against other building-materials companies, whose stocks trade at price-to-earnings ratios of around 15. "The company should be a beneficiary of increased highway spending," Klee says.


  To be sure, much of the gains in these hidden gems may have already occurred, says John Richardson, a portfolio manager at Munder's. "Small-cap value is still trading at discounts and there's still compelling valuation, but it's not as compelling as it was a year ago," Richardson says.

Still, small-cap value plays will likely remain popular with investors for the foreseeable future. If the U.S. economy keeps slowing and Europe and Japan also face slowdowns, investors will be cautious. "When people become sensitive to risk, they take comfort in fundamentals. They look at earnings, book value, and the price they're paying," Richardson says.

And if economies start to turn around, as many economists predict they will be by early 2002 -- well, small-cap value shares tend to fare well early on in economic recoveries, too. Little wonder so many investors are picking through the Russell 2000 trying to find the best ones.

By Amy Tsao

Edited by Thane Peterson

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