Microcap Stocks on a Roll

The market is seeing a resurgence of small-cap stocksespecially the tiniest of the tiny

Small is stylish again on Wall Street.

For a year, equity investors shunned smaller companies in favor of larger, more recognizable names as the slowing economy, credit crisis, and rising commodity prices pummeled the stock market. Starting in early July, however, the market's mood flipped. Money suddenly has poured into small-cap stocks, especially the tiniest of the tiny—the "microcap" stocks.

In the 12 months through June, the large-cap Russell 1000 Index fell 12.36%, while the small-cap Russell 2000 dropped 16.2% and the Russell Microcap Index plummeted 25.47%. From July 1 through Aug. 6, the Russell 1000 is up just 0.36%. But the Russell 2000 rose 5.37%, beaten only by the Russell Microcap Index, which advanced 6.04%, more than any other segment of the market.

Such a reversal is a surprise, but it's certainly not unprecedented for a slice of the market known for wild volatility. Small-cap stocks generally have market capitalizations of less than $2 billion. As for microcaps, the 2,000 companies in the Russell Microcap Index have market caps ranging from $24 million to $750 million, for an average of $287 million. Together companies in the microcap index make up not even 3% of the entire U.S. equity market.

Credit Crisis Has Hurt Microcaps

Microcap stocks have suffered from a range of factors over the past year, observers say. First, smaller companies are seen as riskier, usually for good reasons: They tend to be younger, less well-established, and less diversified—more likely to rely on one product or one customer for the bulk of their profits. In uncertain times, investors tend to dump these stocks, seeking the safe haven of more stable companies or fleeing equities altogether in favor of bonds or commodities.

Of course, the past year has given risk-averse investors extra reasons to prefer bigger companies. For instance, there are many small financial companies, most of them tiny regional banks, but relatively few small energy outfits. In the past year, as the price of oil has skyrocketed, energy companies have surged. Meanwhile, bank stocks suffered from the lingering credit crisis. "The disparity between financials and energy [has] really been dramatic," says Christian Anderson, associate portfolio manager at Russell Investments.

Also, the falling dollar has helped U.S. companies with strong international businesses. "Most small-cap companies' revenue stream is based here in the U.S.," says Steven Rogé, portfolio manager of the Rogé Partners Fund (ROGEX). "A lot of investors wanted to invest in large companies with global franchises."

Since July, the trends hurting small stocks have abated. Financial firms are still reporting weak results, but their stocks have recovered from the rock-bottom prices at the beginning of the summer. Meanwhile, the price of oil has fallen almost 20% from a high of above $147 per barrel, hurting energy companies. "The [small-cap] market had been getting hammered since late November," says Michael Alpert, managing director of J. & W. Seligman. "With oil letting up, we saw a relief rally." Also, the U.S. dollar has stabilized, providing less currency benefit even as many worry that overseas economies are following the U.S. into a slowdown.

Volatile Movements

Of course, it simply could be that smaller stocks had been beaten down so much that a resurgence—what Rogé calls a "dead cat bounce"—was inevitable. Alpert notes that expectations have fallen so far that many small stocks jumped by double digits in one day simply by reporting mediocre earnings.

When profit reports actually impress Wall Street, the movement in a small stock's share price may be astonishing. Penson Worldwide (PNSN) shares, for example, jumped 32% on July 24 after the release of financial results for the company, which provides products and services to the investment industry. Shares of building products maker Trex (TWP) climbed 46% in the two days after it reported its financial results July 30.

The daily movements of small stocks have gotten even wilder as more hedge funds trade and short sell small caps. "These things are bouncing around," Alpert says.

This volatility is a challenge—and an opportunity—for long-term investors. Rogé is "a little more patient getting into small-cap stocks," buying only when shares dip below whatever he judges the stock is worth.

Financials Outlook

Can small stocks maintain their recent trend? Much depends on the direction of financial stocks, which make up more than a fifth of the microcap index. Alpert, whose funds don't own any small-cap banks, says small banks will be "stuck in the mud for a while…We're not through this financial crisis by any means."

Small-cap stocks tend to outperform other segments of the market as the economy exits recession. But Rogé suspects the "economy has further to go down."

Skepticism about the financial sector and economy doesn't mean investors can't find good picks among the thousands of tiny companies on the stock market. The sheer number and variety of small and microcap names make them ideal for investors who know how to spot good values. "It makes for a very advantageous place for active managers," Russell Investments' Anderson says.

For more on the top-performing microcap stocks of the past month, see the accompanying slide show.

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