Wall Street Journal says small caps should rise

Crystal D. Vogt | Jun 02, 2008 10:31am EDT | Comment

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With the onset of a warming trend in the market, small caps may once again be the best place to park your money, according to a May 31 article in The Wall Street Journal.

Although investors are usually drawn to the safety of large caps during the worst of economic times (especially within the last two years), sentiment has recently changed now that the bear market looks to be over. Small caps have pulled ahead of their large-cap brethren, up 4.2% in May compared with 1.6% for the Russell 1000, according to the article, titled “In a Rebound, Small-Cap is Beautiful.”

If the past is any indication of the future, it looks like small-cap issues are on the road to recovery as they not only tend to outdo large caps by a decent margin during a market rebound, but their strong endurance usually lasts for several years after, the article said.

According to Ned Davis Research Inc., since 1979 the Russell 2000 (NYSE:IWM) has returned a median 19.6% in the first three months after a market bottom, versus 13.6% for the Russell 1000. After the 2002 bear market ended, for example, small caps dominated for three straight years.

But why exactly do the little guys tend to come out on top after a darker economic period? A myriad of factors come into play, but the article essentially said it's because small caps are usually unglamorous (meaning they are undervalued), their post-downturn profit bouncebacks have a larger impact than at big companies, and they are more nimble and take quicker advantage of a better economy.

Steven DeSanctis, small-cap strategist at Merrill Lynch, was quoted as naming companies with international exposure as the best investments when coming out of a downturn. In the first quarter, small caps that possessed this bargaining chip rose 13%, while their competition that played in a more domestic field were down 10%.

Health care was mentioned as a sector with high profit potential, due to its tendency to be mostly unaffected by economic cycles. Small-cap tech plays could also be promising, as DeSanctis said that tech did well in the 1990 to 1991 downturn, but failed to bounce back from the 2000 to 2002 bear market only because the sector was still recuperating from the pop of the late-90s’ bubble. He pointed out that foreign exposure for U.S. tech companies is strong.

Investors should keep in mind that small caps are already getting costlier, the story said, partly because of their recent modest rally; the small-cap index trades at 18 times trailing earnings, while the large-cap benchmark is at 16.5 times. Another caveat could be that if severe inflation returns, DeSanctis said, small caps suffer the most as small companies have fewer resources to deal with increasing costs.

Neverthless, surgical instrument maker Conmed Corp. (Nasdaq:CNMD) was named as a promising small cap in the health-care sector. Half of the company’s revenue comes from international sales, and although restructuring has hurt margins, causing it to trade at a high-end 18 times earnings, Conmed has cut debt and is seeing double-digit revenue growth.

Within the tech sector, The Wall Street Journal named cell phone distributor Brightpoint Inc. (Nasdaq:CELL), whose stock is changing hands at 15 times earnings. "They have a 10% global market share," said Chris Guinther, manager of RidgeWorth Small Cap Growth Fund, in the story.