Small caps might still have room to grow

Some investors might believe that small-company stocks are riding high and are due for a fall.

It is understandable if they do. After all, the Russell 2000 Index, which tracks small-cap stocks, continues to garner publicity as it notches new all-time highs, unnerving those investors who believe that all bull markets come to an end sooner or later.

But such views are not new. In December 2004 a newspaper writer – pointing out that the current cycle that began in 1998 was then in its sixth year – asked: “Is the party about over for small-cap funds?”

Turns out it was not. By April 28, 2006, small caps (as measured by the Russell 2000) were 19 percent ahead of their level on December 20, 2004, when the article appeared.

Is the party over now? If small-cap stocks were seen as too high in 2004, surely, some might say, they must be considered too high now that they have grown so much more.

But a closer examination suggests that today’s highs still might not necessarily be excessive; room for more growth might remain.

Here’s why.

Small caps are largely playing catch-up.

Although they have been performing better than large-cap stocks in the last few years, when viewed over a longer time horizon it is apparent that small caps still remain only slightly ahead of their large-cap brethren.

Look at it this way. The large-cap stocks, as measured by the Russell 1000 Index, reached their all-time high in March 2000 and fell precipitously over the next three years before recovering. But all that time, in spite of their sharp fall, the cumulative gains they had made since 1995 put them ahead of small caps’ cumulative gains over the same period.

The figures tell the story: When large caps reached their highest point on March 24, 2000, they were 233 percent ahead of their levels on January 1, 1995, but at that time small caps were only 130 percent ahead of their 1995 levels. Over the next six years small caps edged higher and higher while large caps tended to remain flat.

Earlier this year small caps finally edged ahead and by April 28 this year small-cap stocks were 205 percent ahead of where they were on January 1, 1995 whereas large caps were 192 percent ahead.

But just because small caps have finally caught up with – and even overtaken – large caps does not necessarily mean they are done growing.

Small caps have historically out-performed large caps

According to Ibbotson Associates and using figures dating back to 1926, small-cap stocks historically have earned 12.4 percent a year as against 10.7 percent for large-cap stocks. The historical figures also show that small-cap stocks tend to out-perform large caps for periods lasting between seven and 10 years.

Right now – after smoothing out the bumps along the way – the figures show that over the last decade small caps have advanced at about the same rate as large caps. Since 1996 the Russell 1000 has grown at an average of 9.1 percent a year and the Russell 2000 at 9.6 percent a year.

These figures therefore show that small caps remain below their historical 10-year average of 12.4 percent a year.

Armed with these statistics, investors might revise their views and conclude that, based on the historical returns, small caps have a ways to go before they are exhausted. In other words, small caps have more catching up to do.

But we need to look even closer to get the full picture.

Most small-cap returns recently have been concentrated among value stocks

Closer examination shows that most of the recent growth in small-cap stocks has been concentrated in value stocks. (Value stocks are those that are considered to be trading below their potential as measured by price, earnings and other factors.) The Russell 2000 Value Index is ahead 17 percent a year since April 28, 2000 whereas the Russell 2000 Growth Index has advanced 0.6 percent a year over the same time. (Growth stocks are those whose profits and sales are growing more than the industry average.)

If there is room to grow, therefore, that growth might take place more in small-cap growth stocks than in small-cap value stocks. Indeed, small-cap value stocks appear stretched and are as expensive as they have ever been historically. At the same time, small-cap growth stocks are cheaper than they have been historically.

Although past performance never indicates future results, such an examination might lead investors to conclude that small-cap growth stocks might outperform small-cap value stocks for the next 18 to 24 months as small-cap stocks generally pull up closer to their long-term average growth rate of 12.4 percent.

Of course, the markets are always subject to unforeseen economic events and sharp swings up and down might take place. As always, investors should diversify across asset classes so they are ready whatever happens.