Small Cap Stocks Pick Up Steam; Russell 2000 Shines

Finally, the chart small-stock lovers have been waiting for.

The C-Cube Microsystems and the Kulicke & Soffa Industries of the world outperformed the Gillettes and the Procter & Gambles in August.

And the Russell 2000, which measures the stock prices of companies just below the nation’s 1,000 largest, outshone the big-shot Dow Jones industrial average and the Standard & Poor’s 500-stock index over the same period.

The relatively improving performance of small stocks in August, as well as during the course of the whole year, also helped a majority of active stock-picking managers of mutual funds beat out managers of indexed funds, a feat not achieved for more than three years. The active managers had tended to shy away from some of the market’s best-loved stocks, such as McDonald’s and Merck, because their share prices relative to their projected earnings were too high. That strategy had caused them nothing but woe, until last month.

The big question, analysts say, is whether small stocks can continue their comeback. And Wall Street is not sure they can.

“Small stocks have a lot better fundamental picture given where valuation levels are than large stocks,” said Claudia Mott, who tracks small-capitalization stocks for Prudential Securities. Still, she added that small caps have done better “because we’ve seen a lack of sellers on down days. Now what we need are buyers for the up days.”

Mott noted that smaller stocks achieved stronger earnings growth in the second quarter than big-company stocks, especially in the small-cap technology sector, which has been overshadowed in recent quarters by double-digit gains at technology giants such as Intel and Microsoft. Coca-Cola and Gillette have already warned analysts that third-quarter earnings will not be as robust as once expected, and Mott said that if other large companies “pre-announce” earnings disappointments, investors will likely send more dollars to small-company stocks.

Goldman, Sachs & Co. strategist Abby Joseph Cohen has been predicting brighter days for small stocks for months. She noted in a fax to clients last month that the earnings disappointments in big-cap stocks “have exposed the gap in relative valuations.” She noted investors had been willing to pay a big premium for high-quality stocks with consistently strong earnings. But those prices “may be judged too rich in the case of earnings shortfalls relative to consensus expectations.”

Benjamin Poor of Kanon Bloch Carre, said whatever course small stocks take, the drop in the big market indexes exposes the dangers of investing only in index funds. “People expect the S&P to be less volatile than sectors like technology stocks, but that wasn’t the case in August,” Poor said.