Small-company stocks lack enough heft; Solid earnings, low price still not enough for buyers


What does it take for a small company to get Wall Street's attention?

Strong earnings and a cheap stock don't seem to be enough. The billions of dollars floating around the stock market are picking large-company stocks like never before.

But maybe you haven't noticed that small stocks have been in something of a bear market since 1994. It's not that their prices have fallen. It's that their prices haven't risen even half as much as prices of big stocks.

Returns on big stocks were so much higher last year -- more than 25 percentage points higher -- that the chasm became extreme.

"You can't go back in history and find anything that big or bigger. There's tremendous bias against small stocks," said Mark Seferovich, who manages the small-stock United New Concepts Fund at Waddell & Reed Financial Inc. in Overland Park, Kan.

Along the way, small-company stocks have enjoyed short respites from this trend, and the fourth quarter was one. Some of the best gains among mutual funds came from those that focus on small and midsize companies.

Managers of small-stock funds aren't ready to declare a turnaround. They see some forces working in small stocks' favor, and they're sure that small stocks will again have their day. They're just not sure when.

One way to measure the disappointment among small stocks is to turn the calendar back five years. Imagine it's early 1994 and an investor opens two mutual fund accounts. He puts $100,000 in a fund that invests in the Standard & Poor's 500 index of large-company stocks. And he puts $100,000 into a fund that invests in the Russell 2000 index of small-company stocks.

By the end of 1998, the Russell 2000 account has grown handsomely. The $100,000 investment has become $158,320. That's an average annual gain of almost 10 percent a year, about what experts say stocks generally earn over time.

The S&P; 500 account, however, has grown to $284,090. That's a 23.7 percent average annual gain.

There are many reasons small stocks have been left behind.

One problem for small stocks has been increasing competition from one another. Wall Street's long climb has lured more and more companies into offering stock publicly for the first time. And most of those initial public offerings involved small companies.

The supply of small-company stocks is up, but demand is down. And some of the blame might fall on the fund industry.

Large-company stocks have been feeding on the rising popularity of index funds, chiefly because of the way indexes operate.

The S&P; 500 index, the index most mimicked by mutual funds, doesn't count the stock returns of all 500 companies equally. It puts more weight on larger companies.

Index fund managers who are trying to duplicate the index have to load up on stocks of these big companies. And, as the funds invest more in those big-company stocks, the stocks' prices go up. That drives up the companies' market capitalization and their "share" of the index. Thus, when investors put new money in the index fund, the manager has to put even more of it into the large-company stocks.

Jim Schier, who manages smaller-stock funds at the Security Benefit Group in Topeka, Kan., says many funds are too big to consider buying small-company stocks.

A year ago, Schier considered the plight of a manager in charge of a $10 billion fund. To make each stock choice meaningful, Schier said, the manager might want to invest at least 1 percent of the fund in that stock. That's a $100 million investment for a $10 billion fund. But a $100 million investment in a small company, worth $1 billion, means that the fund would have to buy 10 percent of the company's stock.

Professional investors also like larger-company stocks because they're more actively traded than small-company stocks. An actively traded stock allows the owner to easily find buyers without a big discount on the share price.

Some managers see hope in recessions in Asia and Latin America cutting into the profits of big companies that do a lot of business abroad.

Small companies are more likely to escape those setbacks because they're less involved abroad. If the trend widens, Schier said, even managers of $10 billion funds will have to consider smaller-company stocks to find companies with strong earnings growth.

Pub Date: 2/14/99

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