Of all theories on how to make money in the stock market, fe have more devoted advocates than the one holding that stocks of small companies outperform the broad market over time.
And few have more severely tested the faith of believers -- including those who manage and invest in mutual funds concentrated in small company stocks.
The theory is based on studies, conducted years ago, that compared the performance of "small cap" company stocks with the market as measured by the Standard & Poor's 500 Index, which reflects "large cap" companies. ("Small cap" companies were defined as those whose capitalizations, or shares' total market values, ranked in the bottom one-fifth of all firms listed on the New York Stock Exchange.)
For most of the 1980s, it didn't hold. Small company stocks lagged the index during periods when it rose and fell more than the index when it dropped. There were, of course, explanations: Investors sought the perceived safety of large companies, foreigners preferred to invest in companies they knew, takeovers inflated the prices of targeted companies' stocks, and so on. But they provided little consolation for those who kept the faith.
Then suddenly, without warning, things changed late last year. As the stock market bounced off its cyclical bottom in October, small company stocks -- notably those of health-care and technology companies -- were in the lead. They lifted small company growth funds and vindicated portfolio managers -- including John H. Laporte of T. Rowe Price New Horizons, the oldest and largest ($1.2 billion) such fund -- who had stuck to the strategy.
By now, small company growth funds have soared an average of about 50 percent, leaving broadly diversified stock funds behind, according to Lipper Analytical Services.
If you haven't been along for the ride, can you still expect to enjoy above-market performance from one of the funds in the group?
Laporte thinks that you can, although the pace may be more moderate and may be interrupted by corrections. He gives three reasons:
* Small company stocks still offer attractive values, even if they're not bargains. The price-earnings ratio of stocks in his fund is about 1.2 times that of the S&P; 500's P/E ratio. At this level, this widely followed benchmark, which had dipped below 1.0 in October, is at the low end of its range. Whenever it had fallen to 1.0 in the past, it had gone to over 2.0 before topping out -- and eventually dropping back to 1.0 again.
* The down cycle that ended last fall had lasted about six years, as had the preceding up cycle. Even if changes in financial markets occur at a faster pace nowadays, Laporte believes the new cycle could last as long as four years.
* Investor interest -- including that of foreigners -- in small company stocks has become more widespread for a variety of reasons, such as the ability of many small companies to sustain earnings growth during a recession.
If you find all this encouraging, how do you go about selecting a superior small company growth fund?
Of the 90 funds classified by Lipper, the top 10 performers of the last five years are listed in the table. The wide range of total returns reflects differences in investment objectives, as well as expenses and other factors. And it underscores the importance of comparing fund prospectuses to find one that's suitable for you.
To start, there is no unanimity within the group on what constitutes a "small" company, whether to include medium-size companies -- or even what is to be measured.
For many, capitalization is the basis, but they don't agree on what the maximum should be -- whether, say, $250 million or a higher figure, such as Hartwell Emerging Growth Fund's $500 million.
Still other funds, such as Nicholas II and Scudder Development, use sales revenues.
Scudder's Roy McKay finds that market capitalization fluctuates too much and believes the focus on sales underscores the quest for growth in earnings. In targeting companies with revenues of up to $500 million, he has built a portfolio of companies with median revenues of $150 million and median capitalization of $340 million.