Saturday, July 3, 2004

Extreme investing is often bruising

By John Waggoner
USA Today

Small-company stocks reveal interesting traits when examined closely. But rather than examining them piece by piece, you're better off buying the entire universe - or staying home entirely.

People are attracted to small-company stocks because they can produce outsized returns. The past five years, for example, the Standard & Poor's 600 index of small-company stocks has gained 68 percent, including reinvested dividends, versus a 7 percent loss for the large-cap Standard & Poor's 500 index.

Smaller has been better the past 12 months, too. Suppose you sorted the S&P 500 by market capitalization - share price multiplied by the number of shares outstanding. The 50 smallest stocks in the S&P have gained an average 25 percent. The largest 50 rose just 13.7 percent.

A closer look at the S&P 500's smallest 50 stocks reveals a peculiar world of extreme - well, extremes. The top performer, Allegheny Technologies, a metals producer, soared 176 percent. The worst, Delta Air Lines, plunged 50 percent. In contrast, the index's largest 50 stocks ranged from a 95 percent gain for wireless giant Qualcomm to a 21 percent loss for pharmaceutical company Wyeth.

That big range of returns is not a 12-month phenomenon. Analyst Hugh Whelan at ING Investment Management looked at the returns from the 50 smallest S&P 500 stocks every month since 1972 and found a similarly wide range. What's more, he writes, the median small stock - half are higher, half lower - underperformed the S&P 500. If you chose randomly among the S&P 500's smallest, you'd probably pick a loser. His conclusion: Most of the gains from the small-stock group came from a few big winners, not because the group as a whole returned more. Your best bet, then, would be to invest in all 50 stocks rather than try to choose among them.

But before you travel to the world of small-company stocks, you need to ask whether the trip is worth it.

Unfortunately, big-gain periods for small-caps have been scarce the past two decades. And that's another problem: Small-company funds can be out of favor for a long, long time. Consider the mega-bull market that began in August 1982 and expired messily in March 2000. The S&P 500 gained 2,050 percent, or an average of about 19 percent a year. The small-cap Russell 2000 gained 990 percent, or 14.5 percent a year.

Within the bull market, small-caps had some great years. "Timing is everything with small stocks," says Howard Silverblatt, equity analyst at S&P. The timing might not be great for small-caps now. Post-recession years have been the best years for small-cap funds. The recession ended in November 2001, according to the National Bureau of Economic Research. Economic growth has been brisk this year, which means we're past the early stages.

Small-caps aren't exactly cheap anymore. The S&P 500 now has a price-to-earnings ratio of 18, which means it trades for 18 times its past 12 months' earnings.

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