Small-stock exasperation continues; There is value there, as even big caps know


The outlook for small-company stocks is lost between bemusement about Internet stocks and the run-up to the 10,000 mark of the Dow Jones industrial average.

For many mutual fund investors, the small-stock story is important, however, because most fund managers buy stocks that aren't in the Dow or the Internet bubble.

It's hard to justify paying a professional manager to pick among the biggest stocks when information about them is so widely available, or to roll the dice on Internet stocks when you can do that yourself just as effectively.

With small-company stocks, there's at least the hope that professional money managers can earn their fees by discovering hidden values. But to judge by small-company stock indexes, the only discovery lately has been a dry well.

The stock market today is enthralled in the dominance of a few megastocks, similar to the Nifty 50 era of the early 1970s.

Today's list would include giant computer-technology companies such as Microsoft Corp., Intel Corp. and Dell Computer Corp. The prices of these stocks relative to their earnings track records have been bid up to historic levels, as measured by the price/earnings ratio, or P/E.

Meanwhile, small-company stocks are selling for far less than normal, by any measure.

Jeremy Siegel, professor of finance at the Wharton School at the University of Pennsylvania and an adviser to Chicago-based investment manager John Nuveen & Co., disagrees that an irrational gap has developed between the valuations of big and small stocks.

"There is a perception by investors that the big-cap multinational stocks have a presence in the global economy that a lot of small-cap stocks do not," he said. "They will have staying power. The question is, will the investors have staying power?"

Siegel said if you take out an extraordinary winning streak for small-company stocks between 1973 and 1985, the statistical case is weak that small-cap stocks outperform large-caps over the long run, as many academic studies have concluded.

"I'm not relinquishing my tilt," he said. " I like big-cap growth stocks."

Oddly, so does Preston Athey, manager of the T. Rowe Price Small-Cap Value Fund.

Athey does not see the big vs. small issue as a zero-sum game. He believes that the outlook for his sector looks better every day that large-company stocks prosper.

In recent months, relatively poor performances by his firm's small-cap funds have led to net redemptions by individuals. But Athey has his eye on another type of small-cap investor: big companies. "Corporate America is [recognizing] the extraordinary values in small-cap stocks today," he said. "The buyers are the large companies with high-P/E stocks or cash. Today, the cost of borrowing is cheap and the cost of equity with high P/Es is cheap."

Last year, 16 companies that Athey held in his 225-stock portfolio were acquired by larger companies for stock or cash at prices on average 25 percent above the market price before the merger was announced. And the pace of these high-premium takeover deals is heating up, he said.

For example, on Jan. 7, Illinois Tool Works in Glenview said it would buy one of Athey's companies, Trident International, a maker of industrial ink-jet systems, for a whopping premium of 78 percent over Trident's then-market price.

The all-cash transaction will immediately boost ITW's earnings per share and enable ITW to enhance its broad product line, he said.

Athey rejects the argument he made 18 months ago that a slump in large-cap stocks is needed to draw investors to small-cap stocks: "If we have a bear market in big stocks, we're going to have a bear market in small stocks."

Nor is he depending on the law of averages to bring new investor cash into small-cap funds after a period of redemptions. "It's not because people are putting money" into small-cap funds, he said. "It's because our stocks are being bought out."

The major question is "will there be enough merger and acquisition activity to make a noticeable difference in the performance of small-cap indexes and in funds like mine?" he said.

If there is, big-cap Siegel and small-cap Athey could both be right: large-cap stocks could continue to rally and small-caps could catch up.

Pub Date: 1/31/99

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