Small-cap run may still have legs

For those advisers who missed out on the massive run-up in small-cap stocks since March, don't fret — some market observers still see plenty more upside. Since bottoming out March 9, the small-cap S&P 600 rose 72.9% through Nov. 11, more than 10 percentage points higher than the S&P 500's gain. “We still think there's room for [U.S. small-caps] to go up more,” said Kevin Gardiner, head of investment strategy for Europe, the Middle East and Africa at Barclays Wealth in London, which recommends overweighting small U.S. stocks. Small foreign stocks also have been outperforming their larger-cap peers. The MSCI Barra EAFE Small Core index was up 85% since March 9, compared with the EAFE Large Core index's return of 74.6%. The EAFE indexes include Europe, Australasia and the Far East. “As people look at the economic[-recovery] story, rather than the [recovery from the] financial crisis, we think they'll look more at small-caps,” Mr. Gardiner said. That's because small stocks enjoy better growth prospects than larger, more mature companies, especially in a slow-growth environment. “Earnings growth drives stock prices over the long term,” said Dan Chace, lead manager of the Wasatch Micro Cap Fund (WMICX), which is advised by Wasatch Advisors Inc. “Out of thousands of small companies, you can find ones that will just grow faster than large companies,” he said. It's normal for small-caps to do well coming out of a recession. But what gives some observers confidence now is that the outperformance of small-caps has been relatively muted compared with past recoveries. In the past five U.S. recessions going back to 1973, the S&P 600 has gained an average of 24.2% during the first six months of an economic recovery, said Pierre LaPointe, market strategist at National Bank Financial Group. The S&P 500 averaged about half of that — an 11.7% return — during the first six months, he said. “People are looking for riskier assets” with higher growth potential after a downturn, Mr. LaPointe said. “In the U.S., the [small-cap] sector is lagging behind where it usually would in this cycle,” Mr. Gardiner said. The outperformance by smaller stocks “tends to persist for a year after the end of a recession,” Mr. Chace said. “That's been pretty consistent over the last 10 recessions.” A recent study by Bridgeway Capital Management Inc. that looked at recessions since 1948 found that post-recession outperformance for small-caps has tended to last for about three years. The smallest stocks have tended to rebound the most, the report said.

Risks galore

Of course, small-caps come with plenty of risks. If the economic recovery falters, small stocks could get slammed even harder than their larger peers, analysts said. For starters, many small companies don't have the stable and diverse mix of businesses to weather poor economies that larger firms do. Analysts also said smaller companies overall won't benefit as much as their bigger brethren from a cheap dollar, which will drive export demand. Small firms can also be more dependent on outside lenders for capital, unlike larger firms, which can access the capital markets. A case in point was small-business lender CIT Group Inc., which filed for bankruptcy protection this month, leaving many small businesses in the lurch. While small-caps were market leaders in the rally that started in 2003, “some aren't convinced that we'll see another good multiyear stretch” for smaller stocks, said Karin Anderson, a mutual fund analyst at Morningstar Inc. Small-cap value, especially, has outpaced other styles since 2003, she said — a trend that is continuing. Over the 10-year period ended in October, the average small-value fund returned 7.7% per year, compared with 1.9% annually for small-growth funds, according to Morningstar. From March 9 through Nov. 9, small-value funds gained 77%, outpacing the 64% return of small-growth funds. But managers of small-cap funds, some of whom have recently closed down their funds as opportunities have disappeared, don't appear too worried yet, Ms. Anderson said. Although the universe of attractive small stocks is smaller now after prices have run up, managers “still say there's good value among [small companies] with not much debt [and] a lot of cash flow,” she said. E-mail Dan Jamieson at djamieson@investmentnews.com.