Time to think small

Market outlook

Small-cap stocks have bounced back into favor - spurred by a slowing but steady economy, low interest rates, low inflation, and public demand for technology products, particularly from computer companies.

"Valuations have gotten so compelling" that the entire small-cap sector is being sought out by investors, says Scott Cooley, an analyst with information-firm Morningstar Inc., Chicago.

Valuations are the way a company's stock price is measured and compared with that of competitors. One popular valuation is to divide a company's stock price by its annual earnings, then compare that ratio with those of similar firms.

The stocks of many small companies were hit hard this summer, as investors pulled out of the stock market. Stock prices dove, but that just made many small companies inexpensive, especially compared with the valuations for stocks of larger companies, Mr. Cooley says.

The Russell 2000, the main index for small-cap stocks, has soared since its October lows, although for the year it's still down about 9 percent and remains the hardest hit of all the major stock-market sectors.

The Dow Jones Industrial Average, for example, is now up around 19 percent for the year. And the technology-laden Nasdaq Composite Index - another small-cap indicator - has been trading in positive turf, up about 26 percent.

But that disparity between small caps and their larger-company counterparts is precisely what makes the small caps so appealing, analysts say. While large-cap stocks will find it hard to make rapid gains, many small-cap stocks have nowhere to go but up.

Small-cap firms usually have a market capitalization, or total shares traded times price, of less than $1 billion, and, in many cases, under $500 million.

The main catalyst for the small-cap surge appears to be the recent interest-rate cuts by the Federal Reserve, says Cooley. The Fed also cut rates back in 1991 and 1995 and triggered a surge in the small caps.

In recent trading, the small-cap sector has been led by technology firms. But virtually all industry groups within the sector have shown strength, analysts note. Computer-related firms have done especially well, followed by the chip sector, plus financial-service companies. The financial-service sector is the largest component of the Russell 2000 index.

Rao Chalasani, chief market strategist for investment house Everen Securities, Chicago, believes that the current market rally should continue, based on increased liquidity, lower interest rates, and low inflation. The Dow, he believes, should be trading in the 9000 to 9300 point range by year end.

He prefers mid- and small-cap stocks, given their potential for greater gains relative to large-cap firms, which may have already run their course.

Sectors that he likes include communication services, health care, technology, selected consumer cyclicals, energy, and basic industries.

Investment house Salomon Smith Barney also sees potential gains in small caps. High volatility, the firm concludes in a new study, works against small-cap stocks. But with the Fed now seeking to calm markets and reduce volatility, small-cap prospects "appear bright," the report says.

Prudential Securities analyst Frank Ponticello believes that the current small-cap rally is "sustainable," based in part on buying by company "insiders."

Most investors "should have some exposure to the small-cap sector," says Cooley of Morningstar. Younger investors, with a long time horizon, might have 20 percent to 25 percent of their assets in small-cap issues, he says. Investors closer to retirement should have at least 10 percent in small caps to take advantage of their growth potential. Any more than that can bring too much volatility.

Experts suggest starting with funds that have proven track records, since the sector can be volatile. Consistent performance over time usually signals reliability.

And some fund experts suggest owning shares of at least two small-cap funds, a value fund and a growth fund. If that is impossible, consider a blend fund. Morningstar and Value Line both identify the operating styles of the fund.

One important point: The name of a fund does not necessarily identify its style. Some funds with the word "growth" in their name are actually value funds, and vice versa. Look before you buy.

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