The lingering valuation disparity between small and large companies is a buy signal to investors who think the economy is troughing.
In the year following each of the 10 post-World War II recessions, small-cap stocks have outperformed large-caps by 14.1% on average, according to data from Ned Davis Research, a market statistical service. During the 12 months after the recession in 1991, for example, small-caps gained 27.5%, while large-caps tacked on 11%.
Similar relative strength is discernible in the current environment. The
Russell 2000, an index of small-cap stocks, is off 8.8% for the year, while the
S&P 500 is down 15.5% as of yesterday's close.
"Small-caps have demonstrated meaningful leadership since the burst of the stock market bubble," said John Bollinger, president of BollingerCapital Management. "There's no sign of them wanting to give up that role."
Why the positive outlook? Simple: Small-caps are cheaper than their larger brethren. Based on 2002 earnings, the Russell 2000 index has a price-to-earnings ratio of 15, while the S&P 500 index has a P/E of 23.
"Small-caps didn't participate in the rally from 1998 to 2000," says Richard Dickson, a technical analyst at Hilliard Lyons. "They don't have the valuation problems." Dickson's favorite small-caps are health care, food and tobacco stocks.
In addition, small-caps already have taken their recession-related lumps, while a soft economy will continue to hurt bigger corporations. "Large firms are more likely to have international exposure," said Dickson. As a result, a slowdown in the U.S. economy might not affect their earnings statements until later on.
And small-cap stocks benefit disproportionately from falling interest rates. "As rates come down, smaller companies have greater flexibility to expand their margins," said Shakeel Dewji, portfolio manager of Boston Advisor's small-cap pension accounts. That's because blue chips generally have low borrowing costs already.
Whether or not it's the right time to get into small-caps depends on how long the current recession lasts. "If you think the recession will be over early next year, you're probably close to the point where you'd want to get in," said Sam Burns, an analyst at Ned Davis Research.
Among Dewji's stock picks is
, a maker of analog chips, which supplies
( MOT) and defense contractors
With a market cap of $1.08 billion, Microsemi is riding the cusp of small- and mid-cap. Its stock closed at $38 on Wednesday. What Dewji likes about Microsemi is its growth potential, even though the stock isn't cheap. Based on 2001 earnings, it trades at a price-to-earnings multiple of 51. Using 2002 earnings, it has a P/E of 42.
"Semiconductor stocks are the first to turn up with an improvement in the economy," said Dewji. "
But the real growth is going to be in 2003, when telecom businesses come back and the demand cycle forcellular phones comes back."
Dewji also likes
, a provider of salvage vehicle auctionservices. The company enables the insurance industry to sell damaged or stolen vehicles.
With a market capitalization of $1.85 billion, Copart is also more in the mid-cap range. The stock closed at $33.15 on Wednesday. Using 2001 earnings, it has a P/E of 24. And based on 2002 earnings, the stock trades at a P/E of 19.
"Owning 25% of the market share, Copart is the largest in the business," said Dewji. "And it's using economies of scale to raise its sales."