Small caps at last start to lag behind the big boys

The Baltimore Sun

For two years, market watchers have been nagging investors to be careful about overdosing on small-company stocks, and to stop shunning large companies.

But those who listened regretted it, as the smaller stocks continued to outperform - until recently. Now, small caps are lagging, and some experts say it could get much worse.

As fear took hold of investors recently amid signs of a potential credit crunch and worsening housing recession, investors turned away from the most fragile companies, and small-cap mutual funds became fund investors' biggest losers. The "value" variety - or those considered cheaper stocks that may be on shakier ground financially - have been treated the most harshly.

Since the market peaked July 19, investors in small-cap value funds have lost an average of about 10 percent, according to Lipper Inc., which tracks mutual fund performance.

While U.S. stocks of every size took a beating in July, the smallest of the small stocks felt it the most. The Russell Microcap Value Index dropped 8.2 percent in the month, continuing a trend that began a few months ago.

These very small company stocks have declined about 5.2 percent for the year, while large, fast-growing companies fell only about 1.5 percent in July. Given recent strength, they are still up about 6.5 percent for the year.

Russell Investment Group strategist Stephen Wood said he believes large companies have been the most resilient because "there was some valuation attractiveness in this segment."

In other words, a five-year small-cap craze has left the smaller-company stocks significantly more expensive than large companies such as Microsoft Corp., General Electric Co. and Wal-Mart Stores Inc.

Analysts say the more reasonable stock prices, combined with the substantial amount of business that large U.S. companies do in strong overseas markets, will continue to help larger firms.

Small companies can have trouble when the economy slows. They tend to be more dependent on U.S. customers, compared with larger companies.

Among the large companies that make up the Standard & Poor's 500 index, 27.9 percent of total sales come from outside the U.S. The small companies that make up the S&P; 600 index derive only 15.9 percent of sales in international markets, according to Citigroup strategist Lori Calvasina.

"Stocks with the highest international sales exposure have experienced significantly better average performance in recent months," she said. And midsize companies with the highest international sales exposure have had an advantage over small stocks doing a lot of business overseas.

During the past three months, the Russell 2000 index of small companies has declined 2.4 percent, while midcaps have been able to hold onto a 0.2 percent gain. Midsize stocks derive 22.3 percent of their sales overseas and also have been popular targets in the leverage buyout boom.

Besides their domestic focus, small companies tend to be more vulnerable than larger companies when the tap for loans is turned down - as it has been amid a recent lending scare set off by home mortgage losses.

If companies can't borrow money at affordable rates, they may have to curtail business activities. But larger companies often have greater resources to fall back on than smaller companies.

Since 2005, small and very small companies, the microcaps, have had their profits fade. The trend is especially pronounced as second-quarter earnings are being reported, the Leuthold Group said in a recent report.

Gail MarksJarvis writes for Tribune Media Services.

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