Slower Economy Nourishes Market’s Smaller Stocks Rally Resumes After Lapse Prompted By Fed Hikes In 1994
Carlene Murphy Ziegler, one of the Midwest’s most respected stock pickers, points out an interesting phenomenon in the final minutes of recent daily stock trading:
The Russell 2000 index of small-capitalization stocks frequently spikes higher just at the close of trading, and the Dow Jones industrial average spikes lower.
These sell-at-the-close and buy-at-the-close trades indicate that major institutional investors who engage in computer-driven investment strategies are switching serious dollars into the small-capitalization side of the market, which underperformed the blue chips in the first part of the year.
Since the end of May, the Russell 2000 index has climbed 12.6 percent while the Dow Jones industrial average has gained 3.6 percent.
The glamour of technology stocks, many of which are giant companies such as Microsoft and Intel, has grabbed the headlines, but the broad universe of small-capitalization stocks has resumed a rally that began in 1991 and stalled in February 1994, Ziegler believes.
Why? Because the slowdown in the economy this year creates a more favorable environment for owning small companies that, pound for pound, are expanding sales and earnings faster than the giants through the full extent of the business cycle.
“I like a slower economy for my companies,” said Ziegler. “Small companies can show how good they are.”
In addition, the rising value of the dollar against the Japanese yen and German mark tends to hurt largecompany profits more than smallcompany profits.
Ziegler opened the Milwaukee-based independent Artisan Small Cap Fund in April and has about $172 million under management. Previously, she managed equity funds for the Stein Roe mutual fund organization in Chicago and the Strong Funds in Milwaukee. She is a member of the Barron’s 1995 Roundtable of money managers.
Small-cap stocks tend to outperform the broad stock market during fairly long periods that are sometimes followed by long dry spells. The average length of the four small-cap rallies between 1932 and 1983 was 6.3 years. Small stocks outperformed the market for more than eight years from 1975 through 1983 but lagged thereafter until 1991.
The small-cap rally from 1991 until February 1994, when the Federal Reserve began raising interest rates, was too short by historical standards, Ziegler believes. Therefore, the current breakout by small-company stocks is probably a resumption of the 1991 rally.
“We’re about halfway through the cycle,” she said.
Small-company stocks peak when investors push them to extremes. Small-company stocks tend to trade at higher price/earnings ratios than large-company stocks, but when the small-cap P/Es are more than 1.5 times the large-company P/Es, look out below.
Despite the ridiculously high or, in some cases, infinitely high P/Es of some technology stocks, the small-cap universe as a group is trading at about 1.2 times the price/earnings ratio of the Standard & Poor’s 500 blue chips.
There is room for what Ziegler calls “substantial P/E expansion” in the small-company group. The median-market capitalization (share price times shares outstanding) of the 60 stocks in her fund is about $370 million.
Her portfolio is well diversified, with only 17 percent in technology stocks. When the Artisan Small Cap Fund began in April, many of the faddish tech stocks had been bid higher than their potential growth warranted, she said.
Ziegler looks for technology stocks that are not getting rave reviews. For example, Skokie, Ill.-based Bell & Howell, a provider of information-access services, went public in May at $15.50, below the initially indicated price of about $18. The stock has traded recently around $20.
Ziegler’s quick tips for wanna-be stock pickers: Don’t buy what you don’t understand; study the financials; a good business may not be a good stock to buy now; and if the market capitalization is more than two or three times the company’s annual sales, it’s probably overpriced in the stock market.