Stocks: Let's Get Small

Outfits with market caps under $1 billion have impressed, says S&P's Howard Silverblatt. But investors should do research before diving in

Score one for the little guys. On July 20, the S&P SmallCap 600 index reached its highest closing level since its inception in January, 1994. The small-cap market benchmark has had an impressive run, returning a compounded 13.2% per year since its start, reports Standard & Poor's. The 600 has posted positive returns for 8 of the past 10 years and is currently up 6.5% for 2005.

But the headline number masks widely uneven performance among the sectors that make up the index. There's a huge variance among stocks even within sectors, says Howard Silverblatt, a market equity analyst for Standard & Poor's. "It's important not to be seduced by the headlines," says Silverblatt. "Investors need to do their homework now, because small cap are a lot more volatile [than large caps], and more volatility means more risk."

BusinessWeek Online reporter Jeffrey Gangemi recently caught up with Silverblatt to discuss the present and the future of small-cap stocks. Edited excerpts follow.

Note: Silverblatt has no ownership interest in or affiliation with any of the companies under discussion in this interview.

Q: How do you define small-cap stocks?


For a company to be considered for the S&P SmallCap 600 index, it has [to have a market cap] roughly between $300 million to $1 billion. We also look for market value and liquidity -- the number of stocks that are out there and can be traded. We also look at industry representation to make sure we're presenting an accurate representation of the small-cap market.

Q: Within the index, how consistently have the stocks performed?


Although small caps are balanced on an index level, the issues with each sector vary significantly. For example, in the current year to date about 56% of the issues in the SmallCap 600 are up by an average of 21%. But the 44% that makes up the rest are down by 16%. So you've got the good with the bad. From 2003, there are 50 issues that have doubled, but 26 have lost at least 50%. On the small caps, you've got to do your homework a lot more.

Q: How uniformly do they perform within the sectors?


Even within the sectors, they don't act alike. Of all sectors, energy is the most uniform. You can't just pick something based on size, type, or classification. People are saying to buy small caps now, but the breadth [of the small-cap universe] is not that great. Picking individual issues does not give the best chance of good returns.

Q: What sectors within the SmallCap 600 have done especially well?


Energy has done very well and has grown to about 7.5% of the index, whereas it was only 5.5% in 2003.

Q: Telecommunications has done exceedingly poorly in the SmallCap index. Why?


"Poorly" is an understatement. There are only two issues left. It was always small -- less than 1% of the 600. Because telecommunications isn't local and regional anymore, the smaller companies can't compete anymore. If they're doing decently, they get bought out by bigger players. If not, they get squeezed out. Telecommunications is not a good area of investment in small-cap areas.

Q: How does one go about selecting a good small-cap issue?


There are two main kinds of companies, and they each imply a different risk/reward combination. First you have established companies, which tend to have a positive amount of sales over several years. They probably grew up as a small company but they have product and cash flow and are within a growth-oriented market. Many of these companies are in the small-cap index because it just happens to be the current [growth] phase of their company.

The other kind of company tends to be the kind that's just developing, usually within [information technology] or health care. There seems to be potential for a lot of growth, but they don't have a lot of sales yet. They have potential but no current cash flow.

The simplest way to choose is to look at a company with an operating history and to look at how they've done. Are they generating earnings and cash flow? It's also important to look at dividends: A company that pays a dividend normally feels more confident about their earnings. Paying dividends tends to indicate a lot of current cash flow.

Q: Do you have any buys to share from S&P?


At a 5-STARS (strong buy) rating we've got MDC (MDC ) [followed by S&P equity analyst William Mack], which is about a $4 billion company. It does homebuilding, and it's classified under the consumer discretionary sector.

Another consumer discretionary issue that is listed as a strong buy is Guitar Center (GTRC ) [followed by S&P equity analyst Markos Kaminis], which has music-oriented stores. They [are up] about 15% this year.

On the smaller side, at about $580 million, another company is Steak 'n Shake (SNS ) [followed by S&P equity analyst Dennis Milton], which is a restaurant chain in the South, Midwest, and Southwest. They're up about 4% this year but are still a strong buy.

We also have a few technology listings that are classified as strong buys. One is WebEx (WEBX ) [followed by S&P equity analyst Mark Basham], which develops communications software. That's about a $1.3 billion market cap [issue] that's done about 20% this year. And Netgear (NTGR ) [followed by S&P equity analyst Megan Graham-Hackett], which designs networking products for small businesses, is also a strong buy.

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