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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

period.

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

companies.

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.

Thencamegloomyfiguresonhousingand

consumer spending. And Friday, Commerce

revised the second-quarter growth

number down to 1 percent.

Not surprisingly, many economists say

invest

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

suffer disproportionately.”

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

billions.”

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

can.

“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

small-cap sector.

“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

solid returns.

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

the company.

Others find small-cap investment strategies,

well, laughable.

“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

or not.

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.”

Why not?

“They’ve fallen, but they’re not cheap,

yet,” she said. “And that’s annoying.”

podkulc@washpost.com