Surf's Still Up for Small-Cap Stocks

Editor's Note: Arne Alsin's column runs exclusively on RealMoney.com; this is a special free look at his column. For a free trial subscription to RealMoney.com, click here. This article was published May 15, 2002 on RealMoney.

There's been a lot of discussion lately about the outperformance of small-caps relative to large-caps. Many pundits are saying that the game is up, that small-caps are set up for a fall. Are they right? Is the outperformance of smaller companies nearing an end?

I don't think so. Here's why.

Small-cap cycles last a long time.

History shows that cycles favoring small companies last many years. Going back to the beginning of the century, my calculations show these cycles last about seven years, on average, with a range of four to 10 years.

An example is the aftermath of the 1973-74 bear market, which corrected excesses in big-cap stocks, then known as the "Nifty 50" stocks. After the '73-'74 bear market, small-cap value outperformed big-caps for five consecutive years.

Popular prognostications aren't usually right.

I've been hearing about the demise of small-caps too frequently. Anything widely predicted usually doesn't happen. In the past year, for example, many predicted that the U.S. economy was headed for a Japanese-style deflationary spiral. It hasn't happened. Many also have talked about a housing bubble, predicting a collapse in homebuilding stocks. That hasn't happened, either.

The yield curve is steep.

Since World War II, every steep yield curve presaged growth in the economy. The current yield curve is the steepest since World War II, signaling better times ahead.

Just because companies are going to be doing better, though, doesn't mean you can simply buy a basket of stocks, such as the S&P 500, and expect to do well. As I've said in prior columns, the last cycle, which ended in 2000, was the easy cycle. This one is difficult. You have to pick your spots -- like investing in small-caps -- to outperform in this cycle.

Stock-by-stock analysis supports the thesis.

There's nothing magical about what I do: cycling through the same 800 stocks every quarter as I explained in my April 19 column. I don't do technical analysis or look at trends. I just look at the numbers of these companies each and every quarter, searching for quantitative anomalies in specific companies and groups of companies.

What I'm seeing is the same thing that I've been seeing for the past year and a half: The most compelling valuations, by far, are in smaller companies. Yes, the disparity is smaller than two years ago, but it's still quite wide.

It's all about levers.

When I review small companies, I consistently find lots of available levers that can be used to unlock value. I'm not finding the same number in big companies, many of which exhausted their potential levers in the last cycle.

At IBM (IBM), for example, there's no margin leverage. In fact, net margins are unsustainably high, overstated by pension income and creative accounting (e.g., gains used to reduce selling, general and administrative expenses), among other things.

IBM doesn't have a lever in the balance sheet, unnecessarily weakened by years of buying in overvalued stock. And there's no lever in the top line, either. IBM couldn't generate much more than a token bump to sales in the biggest technology cycle of our lifetime. So expecting Big Blue to drive sales a lot higher during a tough cycle is expecting too much.

The law of large numbers will slow down large-caps.

I like to hold companies for several years if they have the potential to multiply in value. The law of large numbers makes that difficult for large companies because high rates of return are difficult to achieve with increasing amounts of equity.

Some of my picks, such as Liz Claiborne (LIZ), Hasbro (HAS), Ethan Allen (ETH) and Raymond James (RJF), which are valued between $1 billion and $3 billion, have a decent chance to become $5 billion to $10 billion companies in the next several years. It will be much more difficult for a company the size of General Electric (GE), a $300 billion company, to grow in value to $700 billion to $1 trillion.

Here's what I said about small-caps last August:

"The most critical period is when one cycle ends and a new cycle begins. It is essential that once you identify what's working in a new cycle, you act. You can then ride the wave while the crowd gradually jumps on board."

The surf is still up in small-caps. Ignore the pundits and ride the wave.

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