Analysts are steadily dropping coverage of small companies, meaning investors will have to do their own homework. But if you're diligent, the trend could lead to buying opportunities.
As Wall Street firms face staff cuts and increased scrutiny from securities regulators, the time and money to spend on small-cap companies is dwindling. Coverage of small caps has fallen about 20% in the past three years, according to Thomson Financial/First Call.
"The bulls on Wall Street are handcuffed to trading highly liquid stocks ... most focus on the 200 largest-cap stocks, which bring more trading volume to the firm," said Rick Wayman, president of
Researchstock.com , an independent equity-research firm.
Among companies with less than $1 billion in market capitalization, 53% have one analyst or less studying them, while the large-caps have 11 or more analysts dedicated to their coverage, according to Researchstocks.com.
Some say the war with Iraq is partly to blame for analysts' lack of attention to small companies. "In the last six months, because of the Iraqi situation, investors have gravitated toward large-cap stocks for their perceived safety," said George Saffaye, small-cap portfolio specialist at Dreyfus. "But we don't mind that. We like the prospects for small-caps in the near future."
Satya Pradhuman, chief small-cap strategist at Merrill Lynch, agrees. According to his calculations, the small-cap market is trading at a 40% discount to the general market on a revenue basis. "These discrepancies between large- and small-caps represent a good investment," he added.
For investors who are willing to do their own research, the trend could mean a chance to unearth some bargains. For instance, a handful of small companies have outpaced the market since the start of the year. Shares of
, a maker of measurement systems, have jumped 65%. (However, it's a $3 stock, which means its percentage gain can look exaggerated.) Communications services provider
j2 Global Communications
, meanwhile, has added 48%, approaching a $30 price tag.
Other examples include
( PRX), a holding company in the drug sector, which has gained 46% this year to almost $43, and wireless technology company
, which has jumped 55% this year to $22.
Still, to be sure, the reduced coverage of small-caps has a downside. Investors who don't have the time or inclination to research small companies may end up avoiding the sector, which could lead to less liquidity and more volatility in small-caps. Individual investors also may be tempted to overcome the information gap by researching small-caps over the Internet -- and experts warn that small-caps can be risky investments for investors to explore it on their own.
Preston Aethy, small-cap portfolio manager at T. Rowe Price, recommends that investors proceed with caution when investing in small companies. "Some of these companies have a bright future, but not much to show today. For those who are willing to take the risk, there are great opportunities out there," he said.
Strategists say being picky is key, because there are plenty of questionable companies among the healthy ones. Investors also need to make sure their stocks are diversified, experts say.
Aethy recommends that investors identify an industry that has good long-term prospects, by looking hard at companies' balance sheets. Otherwise, mutual funds are the way to go, he said, adding that "there are hundreds of small-cap no-load funds out there."
Another problem resulting from dwindling small-cap coverage is that investors could miss out on possible gains. Some experts say that small-caps may be the best-leveraged stocks to take advantage of any potential economic recovery.
"When the economy starts to reaccelerate, the bigger boost will go to the small-caps, so they are looking very attractive relative to large-caps right now," said Stephen DeSanctis, head of small-cap research at Prudential Securities. DeSanctis expects average first-quarter earnings growth of 18% for small-cap companies vs. 7.4% for large corporations in the
. Small-cap profits were up 27.3% in the fourth quarter, compared with 21.7% for large caps, according to a report from Prudential Financial.