The Small Cap Surge

By Josh Lipton, who covers business and markets for Minyanville

NEW YORK (Minyanville) -- Which S&P cap group performed the best in 2010?

Large-cap jumped 12.8% but trailed both mid-cap (24.9%) and small-cap (25.0%).

Indeed, there has been nothing small about the hard upward move in pint-sized stocks. In the last 12 months, investors -- when looking around the equity market for places to commit capital -- decided that smaller is better.

The iShares Russell 2000 Index ( IWM), which includes holdings like Human Genome Sciences ( HGSI), Tupperware Brands ( TUP), and Riverbed Technology ( RVBD) is up more than 22%. The SPDR S&P 500 ( SPY), which includes holdings like Apple ( AAPL), Microsoft ( MSFT), and Exxon ( XOM), is up 11%.
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The recent small-cap surge kicked off in late August. That's when Ben Bernanke opened the door to another round of bond buying, a maneuver known as quantitative easing that's designed to drive down long term interest rates. Low yields would supposedly revive housing, business investment and overall economic activity. The prospect of QE2, along with stronger US economic data, encouraged greater appetite among you and your neighbors for riskier assets like small-cap stocks.

"What we've seen is a return to risk taking in the market," says Kenneth Farsalas, a portfolio manager at Lisle, Illinois-based Oberweis Asset Management, which specializes in small-cap growth stocks.

Indeed, bulls now abound in the canyons of lower Manhattan: Investors' Intelligence bullish sentiment has rebounded to where it was at the all-time market highs of October 2007. The CBOE Volatility Index, otherwise known as the "fear gauge" as it tracks expected volatility in the stock market, is back to levels last seen in the spring, signaling a lack of hand-wringing among traders.

Looking ahead, says strategists and analysts, M&A activity, economic growth and low interest rates should benefit small-cap stocks although, they caution, this run-up has left these companies looking pretty pricey relative to their bigger brethren and perhaps now ripe for a pullback.

Historically, small-caps have usually performed well in the first two years of a new bull market. In the first year, they tend to beat the market 90% of time. In the second year, they usually best the market 60% of the time. Mainly, says S&P's Sam Stovall, small-caps bounce back hard because they usually get beaten so badly in bear markets.

"They have lost so much that they have that much more to regain on the upside," he notes. (In the third year of the bull market, however, large-caps tend to beat small-caps 55% of the time which is one reason Stovall thinks a leadership transition from small to large could happen in 2011).

Small-cap stocks have also piqued the interest of investors in the past year because they've enjoyed such robust earnings growth versus their larger rivals. Right now, analysts expect small-caps to boast year-over-year earnings growth of 127% in 2010 versus 47% for the large-caps and 59% for mid-caps.

In 2011, so analysts forecast, small-caps will see year-over-year earnings growth of 33% versus 13% and 23% for large-cap and mid-cap companies, respectively.

The headline-grabbing recovery in corporate profits among small-caps is one reason why these companies could continue to outperform this year, says Farsalas.

"Smaller-cap companies that can still generate outsized rates of growth can see P/E multiple expansion even from here," he says. "And investors will be willing to pay a higher multiple for those companies in an environment where the overall rates of growth are going to decelerate."

(For more on the recovery in corporate profits, and what analysts expect in 2011, check out our recent article, Earnings Season Kicks Off).

Here's another reason why Farsalas remains upbeat on the universe he covers: money flowing out of bond funds could help small-caps in 2011, he says. Weekly ICI data indicates that domestic equity fund flows turned positive in the final week of December. Lipper reports that money flows to small and mid-cap funds have turned positive in recent months. Money flows to large-cap funds have remained negative.

The potential for a new cash infusion keeps Farsalas optimistic. "Potential fund flows could be huge for equities in general and for small-cap stocks specifically," he says.

Credit Suisse analysts, however, take a more guarded view of the small-cap outlook this year. In a recent research note, they argued that this year will likely be "good" but not "great" for small- caps. Specifically, they're expecting the Russell 2000 to rise 10-14% in a choppy 2011.

One reason for caution: these small companies aren't looking cheap, in their opinion. They note that the Russell 2000 is now trading at 17 times expected earnings, a multiple that has warned of corrections several times since March 2009.

"To be blunt, we are spooked by this data point," the analysts wrote their clients this week. "We have seen five different corrections in small-caps totaling 10% or more since March 2009 equity market lows. In most of these, we recall the Russell 2000 forward P/E hitting 17x on an intra month basis just before the rally fizzled.

Josh Lipton is a Staff Writer at Minyanville.com.

Minyanville is an Emmy Award-winning financial news Web site that provides a portfolio of applications and subscription products geared toward professional and active investors.

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