Good Things in Small Packages

Small caps look likely to ride a recovery wave clear into 2004

Whenever the stock market stages a comeback, small-cap stocks are usually the opening act. This year is no exception: The Russell 2000 is up 17.4% through June 13, outpacing the broader market indexes. And that's likely to continue. Subodh Kumar, strategist for CIBC World Markets in Toronto, says "The recent stirrings of small- and mid-cap recovery are likely to continue into 2004."

The best news for the sector is what counts most: earnings. Companies in the Standard & Poor's SmallCap 600 stock index should see profits soar 25% next year, vs. 14% for the larger companies in the S&P 500. Small companies are more sensitive to changes in the economy -- for better or for worse -- and can enjoy exponential profit growth as the good times begin to roll. They also benefit as investors grow confident about the big picture and willingly take on more risk.

Small-cap fund managers often get ahead of the crowd. Consider the $225 million Hotchkis & Wiley Small Cap Value Fund, up 23.5% so far this year. Co-manager James Miles forecasts that many of his stocks could double from here. Lawson Software (LWSN ) an enterprise-software company targeting service industries is one such holding. The company has $3.25 of cash per share on the books and no debt. Pathmark Stores (PTMK ) a supermarket chain in the Northeast, is trading for just about the value of its real estate, he says: "You get the rest of the business for free."

There are plenty of gems to be found among small tech outfits. John Montgomery, portfolio manager at $800 million Bridgeway Capital Management, uses a computerized system to find such stocks as Digital River (DRIV ), an outsourcing company that facilitates e-commerce services, including transaction processing. Digital, which specializes in publishers and online retailers, "would have once had a dot-com next to its name," he says. "But this is a real company with real revenues that hasn't burned through its cash." Sales at the Eden Prairie (Minn.) outfit grew 36% in the first quarter. Montgomery also likes Factual Data, which provides data services such as credit reports to the mortgage industry. At $17, the stock is trading at 13 times expected 2004 earnings, about half the industry average. "You're looking at 80% growth in the stock," he says.

Despite their recent runup, small caps are still relatively cheap. Bill McVail manages the Turner Small Cap Growth fund, up 24.9% this year. One stock he's bullish on: entertainment outfit Marvel Enterprises (MVL ). It has a library of characters, such as X-Men and Spider-Man, built over 30 years that it can license and market. It reported record first-quarter earnings of 57 cents a share, up from a 10 cents loss last year, and trades at 20 times next year's $1.25 per share forecast. Its stock is up fourfold in 12 months, but "there's still plenty of upside," says McVail.

While small-cap talent looks promising, there are some obstacles. Recent tax changes favor big companies that pay dividends. Low inflation helps low-cost producers with economies of scale. And a falling dollar does little for small companies without multinational operations. But if the economy revs up in 2004, says Mark Basham, director of S&P small-cap research, "Small companies should overcome all these hurdles."

Even if the recovery flattens, small-cap investors may have less to worry about: For the eight years of the last sideways market, 1975 to 1982, small-cap shares averaged a 34.8% annual gain. That certainly offers investors something to go for.

By Mara Der Hovanesian

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