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Small caps losing their edge over blue chips

Could David be losing his historical edge over Goliath in the stock market? Investors are starting to wonder.
/ Source: The Associated Press

Could David be losing his historical edge over Goliath in the stock market? Investors are starting to wonder.

Small-cap stocks have lost their sizzle in recent months, falling 12 percent and underperforming blue chips since the market's powerful 13-month rally ended in April.

Such price swings are hardly unusual, and that's only part of the evidence that suggests their latest run of dominance over large-company stocks is ending. Some experts contend they are as overpriced as they've been in three decades.

A new study by BNY Mellon Beta Management highlights small caps' vulnerability. Investors, the study found, are no longer compensated for the extra risks they take buying small stocks.

"Right now there's no benefit to investing in small caps versus large caps," says Mark Keleher, CEO of the San Francisco-based investment firm. "The optimum time to invest in small caps may have passed."

Investors apparently are reaching the same conclusion.

U.S. small-cap funds saw outflows of $822 million for the week that ended Wednesday, according to EPFR Global, a Boston-based firm that tracks global fund flow data. That tipped fund flows into negative territory for 2010. Less than four months after the year-to-date total reached $6.3 billion in inflows, it is now at $689.8 million in outflows.

Melissa Wedel, a research analyst at Litman/Gregory Asset Management in Orinda, Calif., has noticed a flight to higher-quality blue chip stocks from small caps among fund managers.

"Small caps are not an area one would want to be in too heavily right now," she says, citing their comparatively higher valuations.

But the notion of small caps as laggards runs counter to what every student of investing learns early on. Small stocks as a group have outperformed large ones for at least three-quarters of a century.

Small-cap stocks, or those with market capitalizations between $160 million and $2 billion, have netted investors an average 2 percent higher annualized returns than large caps since 1927, according to Ibbotson Associates.

The performance gap widened dramatically after 2000. The Russell 2000 index of smaller companies has beaten the Standard & Poor's 500 index, a common yardstick for large caps, in every year of the past decade except 2007. It's up 29 percent from 10 years ago, compared with a 23 percent drop for the S&P.

A $10,000 investment in the Russell 2000 at the start of 2000 would have grown to $14,802 as of July 31, assuming all distributions reinvested, according to Morningstar Inc. The same amount put into the S&P would have shrunk to $9,080.

Small has proven better than big over the long run for several reasons.

Small companies can react faster to changes in the business environment and grow faster. They thrive when interest rates are low and financing their growth doesn't cost as much. The comparative lack of information also means there are more opportunities for small stocks to be mispriced.

More recently, they have benefited by having limited exposure to Europe. And small caps tend to lead the way during economic recoveries; they've outperformed large caps in the first year following each of the last nine recessions.

What's changed about their outlook is partly a question of timing.

If the recession ended just over a year ago, as most economists think, that means small companies' post-recession resurgence could be largely over.

Some analysts also say the nearly unprecedented 118 percent run-up small-cap stocks enjoyed from March 2009 to late April 2010 pumped their valuations too much.

The BNY Mellon study forecast approximately equal returns for small and large caps over the next three years — a period during which interest rates are expected to rise. This is the first time since 1983, it said, that investors get no premium for sinking money into companies that have less liquidity and higher transaction costs.

But small cap boosters say concerns about the short term are overstated. Bill McVail, small-cap growth portfolio manager at Turner Investment Partners in Berwyn, Pa., says smaller companies are poised to expand as soon as employment and consumer sentiment turn around.

"Yes, they're a little more expensive than the S&P, but their earnings growth is seemingly higher" than large caps', he says.

Chris Retzler, portfolio manager for the Needham Small Cap Growth Fund, says long-term investors still can find bargains. Small-cap health care stocks, he says, for instance, have been avoided because of ongoing uncertainty over health care reforms. So they're a great buying opportunity.

Even doubters aren't saying small stocks are a terrible investment. It's just that they're no longer the near-automatic winner over large caps that they've long been.

Dirk Van Dijk, senior equity strategist for Zacks Investment Research in Chicago, is among those who now lean toward large caps that are now loaded with cash, strong balance sheets and strong credit.

"There are really good investment opportunities in good, stable, safe companies," he says, citing Microsoft Corp. as a prominent example. "Why take the risk in companies that you have less information about, that have less access to capital and are probably dependent on one or two major customers?"