Note: This article first appear on November 25, 2005. Please visit our Retirement Planning or our Mutual Fund pages for up-to-date news, information , guides and books.
If you have been watching the business channels of late, you have heard one talking head after another claim that the current market environment is ripe for blue chip companies to take off. This much anticipated event has not happened yet and probably won't in any significant way in the near future.
While the reasons are many and include uncertainty about inflation and the Federal Reserve's new chairman handling of it, the twin deficits, and the fact that historically, second term Presidents are not market friendly - this administration may be doubly bad for the markets - there is one place that has weathered any number of storms over the past five years or so and outperformed: Small caps.
Small Cap stocks, those that generally have a market capitalization of a billion dollars or less have had a spectacular run. These companies, members of the broad based index in the Russell 2000 and even more accurately in the S&P 600, have given small cap investors rewards with bragging rights. The numbers prove that these investors have seen their investment grow over a 100% dating back to April of 1999. Not bad when you consider that the big caps measured by the S&P 500 have a negative return for the same time period.
That fact alone, stirs a deep human tendency to jump right in, chasing a leader when the frontrunner may be on the way down. Question is: Is there any wind left in the small cap sails?
Let's first discuss how these stocks are listed and whether you should buy them as an index or as an actively managed fund. The Russell 2000 index lists 2000 of the smallest companies but with slightly different statistical returns than the S&P 600 index of small cap companies. When you look at the trailing P/E (price to earnings, a good measure of the overall value of the group - too high and the group might seem expensive, too low and the worry of undervaluation takes over), the fact that the Russell 2000 includes somewhat larger companies than the S&P 600 index and a good deal of those included in the all-inclusive universe do not have any earnings to speak of, the ratio would be considered high. Recently, Thompson Financial had reported the Russell 2000 at a p/e of 32.5. The lack of earning power has dragged that index down giving the group an overall of return roughly half as much as the S&P 600.
The S&P 600 may be a better index of stocks and not just because its p/e is much lower - around 19. The companies included in this index are listed because of their ability to report four consecutive quarters of profits.
That may be the best difference that investors are looking for when trying to play this sector. Profitability will be the one factor that will keep this group afloat during the coming economic soft spot. Much like their big cap brethren, survival will depend on coffers flush with cash, the ability to tap readily available sources of cash at both banks and in the high yield corporate marketplace, and a rosy picture of future earnings growth.
With core and non-core consumer price indexes up and looking to end the year that way, small businesses may actually have more upside in a difficult market than past cycles have allowed. Even in a wait-and-see environment, even with inflation poised to take off, and even with the distinct possibility that next year is not going to be a banner year for stocks, it is difficult to see anything but a bullish future for this group.
If the large caps do actually have a year that show them, as a group, up over 15%, you can expect small caps to beat that mark by an additional 5%.
So how do you play this particular sector? Actively managed funds tend to be more expensive to run that indices of the sector. One of the top funds over the past three years, the Needham Small Cap Growth (NESGX) sports a five star Morningstar rating but an expense ratio of 2.52%. The wildly popular Buffalo Small Cap (BUFSX), around since 1998 has a more attractive expense of 1.01% compared to a category average of 1.71%.
Another note of interest is the relative size of the small cap universe. The S&P 600 small cap index comprises just 3% of the total market tracked by Standard and Poors. The Russell 2000 charts a mere 8% of the total. The Morgan Stanley Capital International Inc. ("MSCI") is used by the low expensed Vanguard fund, offers another view of the small cap world. The MSCI index of small cap growth stocks is up 9.22% over a ten year period which compared to an index on large cap growth offerings over the same period is only 7.02%. All of these indexes can be purchased as mutual funds or exchange traded funds. ETF's, it is important to note, are actively traded shares of funds, which means that you do not actually own the fund. Instead, you exchange shares with other investors.