Originally posted @ http://www.ritholtz.com/blog/wp-content/uploads/2011/08/Bank-Gx62.pdf
Beaten-down small-cap stocks could be ready to rally, some say
among professional investors.
“If we’re not in an economic recession,
we could see a decent rally in small-cap
stocks,” said Steven DeSanctis, small-cap
strategist at Bank of America Merrill
Lynch inNew York.
Small-cap stocks have lost so much
value this year — about 25 percent since
their late-April peak, as measured by the
small-cap Russell 2000 index — that De-
Sanctis thinks “flat is the new up”: If they
simply end the year where they started,
investors will see about a 13 percent rally
from where they are now. Large-cap
stocks slid about 18 percent in the same
Bank of America sees a 40 percent
chance of recession, he added.
“That’s really the question that people
have to answer for themselves — ‘Do we
think a recession will occur?’ ” said Matthew
Litfin, a portfolio manager at William
Blair who invests in small- and midsize
Economists have grappled with that
possibility in recent weeks. Inlate July, the
Commerce Department said the economy
grew at snail’s pace of 1.3 percent in the
second quarter and revised its first-quarter
estimates to 0.4 percent. A spate of
weak reports on manufacturing followed.
consumer spending. And Friday, Commerce
revised the second-quarter growth
number down to 1 percent.
Not surprisingly, many economists say
in the past three months. But few
are ready to call it — and therein lies the
opportunity, experts say, for some diversification
into small-cap stocks, best accessed
through mutual funds.
Small firms tend to get hitmuchharder
than big ones during economic downturns
because they often have less diversified
businesses and less cash on hand.
That, inturn,givesbanks secondthoughts
about lending them money, which can
slow their growth even more.
“It’s very hard forthemto get creditand
capital,” said Chris Hanaway, portfolio
manager atWellsFargoAdvisors. “Ifwego
into another global recession, they will
The opposite is true in good times.
Small companies tend to be at an earlier
stage of growth than their bigger counterparts.
“It’s the law of large numbers,” said
Gary Lenhoff, director of small- cap strategy
at Great Lakes Advisors. “It’s harder
forIBMorMicrosoft togrowas fast—they
already have revenues measured in the
So when money’s pouring in, small
companies can plow it back into their
business by buying equipment, opening
stores or acquiring customers that move
the needle on their performance more
than similar actions by larger companies
“That indeed is borne out by the data
over the last 83 years,” said Jay Ritter,
financeprofessor at theUniversityofFlorida.
From 1927 to 2010, small companies
beat large onesbyanaverage of about 0.36
percent a month when the economy was
expanding, Ritter said. In downturns,
they underperformed their larger peers
by about 0.2 percent a month.
The nuance, Ritter said, is that not all
small-cap stocks are created equal. Those
classified as “growth” investments—companies
that are rapidly expanding but
have yet to pay out steady dividends —
tend to be “a triumph of hope over experience”
because they ultimately deliver disappointing
returns, he said.
That isn’t commonly the message one
finds in newsletters dedicated to the
“Technological advancements periodically
come along that exert a profound
influence on not only the business world
but also society as a whole,” said a recent
issue of Cabot Small-Cap Confidential, a
Massachusetts-based newsletter, when it
recommended a “big opportunity” to buy
Digi International, a small-cap firm that
develops communication technology.
“Newsletters like to tout the next
Microsoft,”Ritter said, but “Microsoftwas
never a small-capstock,” andit is extremely
rare for small-capgrowthstocks togrow
into corporate behemoths. Far more common
is for small-cap “value” stocks —
those whose business models are proven
enough that they can consistently pay out
money to their shareholders — to deliver
Wetherell uses dividend initiations as
one proxy for differentiating between
growth and value plays. In January, after
Lincoln Educational Services, a for-profit
college, initiated a 25-cent dividend, his
fund swooped in to buy 8,000 shares.
With the recent meltdown, the company’s
shares tumbled 50 percent, to $9, meaning
it is now paying out an annual dividend
of more than 10 percent.The 10-year
Treasury bond is paying about 2 percent.
“We tend to like plays that are out of
favor,”Wetherell said, sohe’s holdingonto
Others find small-cap investment strategies,
“They really got creamed!” said Timothy
Loughran, who teaches stock valuation
at the University of Notre Dame. He
chuckled when he looked at a stock chart
for Lincoln Educational Services. “I just
don’t think small firms are the way to go.”
Loughran thinks investors should set
aside the question about a recession and
focus more on which emotions will drive
the market in the near future.
“I think the market is more likely to
continue the flight to quality,” he said,
which means large-cap companies like
Apple and Google are likely to see more
demand for their shares than small-caps.
“They’re established, they have lots of
product lines, and—most importantly—
they have huge amounts of cash on hand.”
DeSanctis, the small-cap strategist at
Bank of AmericaMerrill Lynch, concedes
that large-cap companies are likely to beat
their small-cap counterparts next year
because slow economic growth is likely to
translate to weak earnings growth — recession
In January, Lori Calvasina, who researches
small-cap stocks at Credit Suisse,
warned clients to think twice about allocating
more money to the sector because
small-caps’ valuation relative to largecaps
was at a 30-year high. “I’ve basically
been the ‘negative Nellie’ all this year,
irritatingmy clients,” she said.
Now, “I’m getting more interested in
the sector,” she said, but “I’m not pounding
the table by any stretch.”
“They’ve fallen, but they’re not cheap,
yet,” she said. “And that’s annoying.”from G1 the odds of recession increased significantly