BOSTON (TheStreet) -- Small-cap stocks soared to a record last week even as the economy struggles to find its footing, leaving investors to wonder how to adjust their portfolios as volatility ramps up before the summer doldrums take hold.
Mutual fund managers are telling clients to stick with large-cap stocks because they offer greater value.
The Russell 2000, considered the best benchmark of small-cap stocks, jumped to an all-time high last Monday, topping its previous record set in 2007. Since the low set in March 2009, the small-cap index is up more than 140%, outpacing a gain of less than 100% on the broader
index. However, the Russell 2000 declined for the rest of the week as investors sold risk-laden stocks and commodities. Many investors are wondering if small-cap stocks have completed their run.
Flows into small-cap mutual funds show that investors are chasing the performance of small-cap names. According to data from
, small-cap mutual funds have seen an estimated net flow of $13.2 billion since the March 2009 low, while large-cap counterparts have seen outflows of $105.7 billion. Fund managers -- even those who manage small-cap portfolios -- say greater opportunity exists over the long term in large-cap stocks.
Eugene Profit, manager of the
Profit Opportunity Fund
, has a unique perspective as he manages both large-cap and small-cap stocks.
"The market has been rewarding excess risk more than capitalization with respect to stocks. If you look at the Russell 1000 growth, a lot of the returns have been driven by the smaller-capitalization stocks rather than the large-cap staple names," he says.
Profit says money continues to pour into small caps because investors chase what is working. The Federal Reserve's bond-buying program, an effort to support the economy, has rewarded risk-takers, pushing up commodities, technology stocks and small-cap companies.
"The Fed will maneuver away from excess liquidity it has provided and so investors haven't taken a different posture," he says. "When that happens, you'll see a reversion back to the mean with respect to large-cap securities. But until that happens, small-caps will at the very least share the limelight.
Elizabeth Jones, manager of the
Buffalo Large Cap Fund
, encourages investors to spread their money across companies of different sizes. She says that, midway through the economic cycle, large-cap stocks begin performing better than small-caps. That's about to happen.
"Now as we sit here, we have a price-to-earnings multiple of nearly 30 on the Russell 2000 trailing. It's about 15 on the S&P 500," she says. "Looking forward into 2011, it's about 22 on the Russell 2000 and about 13 or so on the S&P 500. When you think about those multiples, large cap looks a lot cheaper. At this point, it seems reasonable to be increasing the weighting in large cap relative to small cap."
Jones points out that earnings on the S&P 500 are expected to grow about 13% from 2010 to 2011, compared to a 40% projected growth rate in earnings on the Russell 2000. "We're not going to say that's going to happen, but certainly there's a lot more risk in that number of 40% growth than there is in 13.5%," she says. "As the cycle progresses, further margin expansion becomes more difficult because companies have to invest for growth. Given the rise of input costs on top of that, it makes that 40% growth a little more difficult to obtain."
Both Jones and Profit have been favorable of large-cap stocks, particularly health-care names. They detail the best health-care stock picks in the portfolios on the following pages.
Elizabeth Jones, manager of the $36 million
Buffalo Large Cap Fund
, has more than 12 years of health-care-industry experience, so she knows a little bit when it comes to researching this sector.
Elizabeth Jones, portfolio manager of the Buffalo Large Cap Fund
"I used to practice medicine -- my expertise is clinical medicine -- so we invest in what we know," Jones says. "We are more invested in product-driven stories. We're traditionally overweight health care because it fits a lot of long-term trends we invest in, but we've been increasing the weight this year."
One of the reasons for the increased weighting in the sector has been its outperformance this year. Health care is up about 12% this year, making it the top-performing sector in the S&P 500. In the past month alone, the industry is up 6%. The health-care sector was the second-largest weighting in the Buffalo Large Cap Fund as of March 31, accounting for nearly 18%, making the fund overweight the sector by at least 900 basis points.
Jones says the outperformance of health-care stocks "suggests there is a little more rotation into some defensive characteristic companies over the past month. It suggests people are getting more conservative. Whether this is going to be short-term rotation or part of a cycle, I don't know."
Although health care has outperformed this year, stocks have P/E multiples that are among the lowest, alongside financials. Jones says these stocks still have room to run, even considering the recent outperformance.
The fund, which targets stocks with a market cap over $10 billion through rigorous valuation screening, analysis of company-specific factors, and fundamental research on industries and the economy, favors
, which has a P/E multiple around 10, indicating value.
"We think it can grow 10% on the top line and mid double digits on the bottom line, which is pretty attractive," Jones says. "They offer treatment for HIV, which is probably one of the most cost effective treatments in all of health care. Take it and you live, and if you don't take it you die. That's a cost of $15,000 per year per individual, as opposed to oncology or MS or Hep-C drugs that are almost double, triple or quadruple the price. It's offering a huge value to patients in terms of life-saving treatment."
Jones says the fund also owns
, which supplies syringes and tubing to hospitals and outpatient clinics. The stock has been considered a play on a rebound in employment, as laid-off workers have put off procedures until they regain health insurance. Jones, though, likes the stock for other reasons.
"Certainly as utilization improves, inpatient volumes go up and inpatient volumes go up, and they should see improvement in volumes," she says. "But it's more than a play on that, since that is short term. They're very focused on diabetes, which is a huge epidemic in this country and growing. They also focus very much on product safety and improving safety, which is a critical concern for hospitals."
, meanwhile, is another play on increased utilization. While Jones shies away from investing in health-care companies where a conflict of interest could exist, she says that's not the case with HealthSouth. "The decision to send the patient to HealthSouth is not made by anyone at HealthSouth. It's made by physicians and practitioners outside of the equation," she says.
Lastly, Jones offers up
as the fund's biggest dividend play. The stock currently has a dividend yield of 4.2%. Jones says she also is a believer in the company's cardiovascular drug pipeline, which the company is not getting credit for in its stock price.
"Assuming they have some positive results in that pipeline, we think the stock will appreciate. While we wait, we get paid over 4%," she says.
Eugene Profit was a standout defensive player for the New England Patriots and the Washington Redskins in the 1980s. Now he manages $2.1 billion in assets as president of Profit Investment Management. He runs the large-cap
Profit Opportunity Fund
, which focuses on small-caps.
Eugene Profit, portfolio manager of the Profit Fund
Profit says he is excited about the Profit Opportunity Fund because the market is leaning toward buying into risk. However, as the market adjusts after the end of the latest round of quantitative easing by the
, he expects that the Profit Fund will see a return to the historical pattern.
"If you ask me that question today, I would point you toward the Profit Opportunity Fund," Profit says. "But because of the dislocation, I would push a longer-term investor toward the Profit Fund."
is the top position in the Profit Fund by weighting, as the fund manager has been impressed with demand for the company's products.
"Look at the Apple store. The stores are still full with people but they can't put enough iPad 2 devices out," Profit says. "For some time to come, this will be a strong growth story. But their iMac sales are again increasing, and that's what we're focusing on. That market share has been steadily increasing as people are exposed to the iPad and iPhone. It's a phenomenal investment story and if you're not a trader, I'd put money to work here."
However, like Jones and the Buffalo Large Cap Fund, Profit has seen health care become the leadership group since the middle of March. "Earnings announcements were incredible across the board," he says. "If you're looking to catch trends early, the bell has already gone off in health care. It may not rocket, I would begin to move money away from energy and reallocate it toward health care."
Profit highlights three health-care picks, including medical-device maker
, which has been a disappointment for investors. The stock is up 15% in 2011, but has rebounded only 44% since the March 2009 low, widely trailing the broader market.
"We've loved this name for quite a while but we've been disappointed with performance," Profit says of Medtronic. "This is one of the names the market has not rewarded. As unemployment has stayed as high as it has, you've had people putting off procedures. There's been confusion around the name. In an improving economic environment, the demand for pacemakers won't go lower because of the aging baby boomer population."
Profit is also a fan of
, which develops and supplies diagnostic tests, medical-imaging systems and surgical products for the health-care needs of women.
"They have the best cervical cancer screening procedure," Profit says. "They also have an excellent sales force. But this has been a company that has had integration issues because of a merger. Last quarter's earnings was good, and the stock is at the start of a pretty solid uptrend."
-- Written by Robert Holmes in Boston
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