Small Caps' Shrinking Appeal

Small-cap stocks' reign over larger rivals may be ending, done in by a weak earnings season and worries about a slow economic recovery.

Small-cap stocks dominated large-cap stocks during the last decade. From 2000 through 2009, the Standard & Poor's SmallCap 600 index rose 68.2%, while the large-cap Standard & Poor's 500 fell 24.1%.

Since the start of 2009, both indexes have lost ground, with a 1.8% decline for the S&P 500 and a 1.1% drop for the S&P 600. (The companies in the S&P 600 each have a market capitalization of $200 million to $1 billion, while S&P 500 market values exceed $3.5 billion.)

Strategists and portfolio managers caution that small caps could fall behind this year. One Bank of America Merrill Lynch (BAC) strategist says concerns are heightened by recent earnings reports.

Now that 70% of large caps have reported fourth-quarter results, Bloomberg data show S&P 500 companies are growing earnings per share 47% over a year ago, beating analysts' expectations by 11.6%. Given the weak economy, even more impressive may be the S&P 500's 7.4% growth in revenues since a year ago.

By contrast, with exactly half the S&P 600 reporting, small-cap stocks have shown slower-than-expected earnings growth and flat revenues. Earnings are up 30.4% from a year ago for the S&P 600, but that is 8.6% less than analysts expected. Fourth-quarter revenues are down 0.3% as of Feb. 16.

"For the small caps to beat the large caps here in 2010, we think we need to see better fundamentals," Bank of America Merrill Lynch small-cap strategist Steven DeSanctis said in a Feb. 11 overview of fourth-quarter earnings to date.

Price Disadvantage

Another disadvantage for small companies is that they've already seen huge price moves in the past year. Since the 2009 lows on Mar. 9, the small-cap S&P 600 is up 80%, compared with 62% for the large-cap S&P 500.

That's typical for small stocks in the early stages of a stock market recovery, but it rarely lasts, says William Delwiche, investment strategist at Robert W. Baird. Now that the bull market "is beginning to age," investors will begin moving up to larger names, says Delwiche. He is advising clients to gradually start buying mid- and large-cap stocks.

Large-cap stocks offer investors more stable business models, less debt, and "more clarity" about their future, Delwiche says. This makes large caps a safe haven for investors in tough market conditions, especially any significant correction that could occur this year. Large caps don't excel when markets are rising, he says, "but [they give] protection on the way down."

Economic conditions could give large-cap companies the advantage in 2010, says Thomas Nyheim, portfolio manager at Christiana Bank & Trust Co. A quick economic recovery would give a "real bounce" to small- or mid-cap stocks, which are often more sensitive to the U.S. economy. But "higher-quality large-cap names" will do better in a slower recovery, which Nyheim is expecting. "The recovery is going to be slower, [with] drags from unemployment," he says.

P-E Ratio Higher Than Usual

After last year's rally, the valuations of small-cap stocks are pricier than usual. The price-earnings ratio for the S&P 600 is 31.5, compared with an average of 21.2 over the past decade. The p-e for the Standard & Poor's MidCap 400 index is 20.6 (compared with a 10-year average of 20). The p-e of the S&P 500 is 18.8, lower than the index's 10-year average of 19.2.

Higher p-e's are often justified by expectations of stronger growth ahead. Here, at least, smaller companies have an advantage. "It's much easier to grow a small company than a large one," says independent market strategist Doug Peta.

Small caps have another advantage: They're less widely owned. Retirement accounts almost always include some variation on the S&P 500 in their holdings, while small-cap holdings are rare. "And, since everybody already owns it, it can't perform as well as less-loved quarters of the market," Peta says.

Alan Gayle, senior investment strategist and director of asset allocation at RidgeWorth Investments, believes pessimism about smaller companies could be an opportunity for investors. Because of the economic recovery, "the outlook for small caps is good," Gayle says. But after small caps' recent market run, and with so much uncertainty about the economy, "I'm a little more nervous over the near term," Gayle says. If small-cap stocks lose ground in the next couple of months, it could be an opportunity to buy stocks for the long term, he says.

Dollar Factor

A key factor for large-cap stocks could be the direction of the U.S. dollar. The large companies that make up the S&P 500 do business all over the world, while many small caps stay close to home.

A stronger dollar makes overseas profits and sales appear smaller when brought home. On Feb. 5, the U.S. Dollar index, measuring the greenback against a basket of global currencies, hit its highest level since July 2009. The dollar is up 8.3% since Nov. 25.

"If the dollar continues to strengthen, that would play into the hands of small caps," Delwiche says. "If it weakens here, that would be an additional impetus for large caps."

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