Small-Stock Story Begins to Take On a Life of Its Own

Small stocks have been the stars of this year’s bull market--most investors know that. But many investors also assume that because small stocks have been so hot for nine months, it must be too late to buy.

What’s going to make the stocks rise from here? the doubters ask. The answer, in part, is that the small-stock story increasingly has the markings of a self-fulfilling prophecy: The longer the stocks hold up, the stronger the feeling that this really is the start of a multi-year bull run in these issues.

That keeps money flowing into the stocks, fulfilling the prophecy and, in the process, renewing it. Growing media coverage, such as columns like this and a Wall Street Journal series this week, assure that the small-stock story is told, increasing the focus on the stocks. (Recall how stories about the birth of takeover mania in 1983-’84 turned many investors into takeover stock speculators for the rest of that decade.)

You can’t underestimate the power of psychology in the stock market--the power of belief in a trend to carry prices to incredible heights. Psychology can override the fundamentals of company earnings, dividends and other factors for a long time.

Between now and the start of 1992, two key elements of the small-stock story will get a lot of publicity, and could make buyers out of many investors who’ve shied from the stocks so far:

* As measured by the NASDAQ composite index of 4,000 mostly small companies, these stocks are having their best year in more than a decade. The NASDAQ index already is up 44% this year, versus a 15% rise in the Dow Jones industrial average.

The NASDAQ stocks’ best performance in the 1980s was the 33.9% rise in 1980. If the NASDAQ index can hold up through the end of the year, the full-year gain is likely to change the minds of more investors who thus far see the small-stock rally as a one- or two-quarter flash in the pan.

* Historically, small stocks perform extremely well in January. Many large and small investors alike start each year with a clean slate and go on January buying sprees, especially for small issues.

Belief in that January rally has become so ingrained on Wall Street that many investors have tried to “front-run” it in recent years: Many buyers have tried to snap up bargains among smaller issues in November and December, rather than wait for January. There’s no reason to believe that that mentality will be different this year.

Psychology aside, however, many investors won’t touch small stocks now unless they believe that the companies’ earnings in 1992 and beyond will justify higher stock prices. On that count too there is reason to be optimistic.

Rex Sinquefield, a principal at Santa Monica-based Dimensional Fund Advisors, is a veteran investor who oversees $6 billion in mostly small stocks. A student of market history, Sinquefield notes that “the earnings of small companies always lead the way out of recessions.”

The big question is, have the stocks’ prices already gotten far ahead of whatever earnings gains will occur next year?

Sinquefield, a strong believer in efficient markets, won’t speculate on how much higher small stocks might go. But he says that in his many discussions with managers of small firms in DFA’s stock portfolio, “we constantly hear how they have pared (costs) down to the bone. So they believe they have enormous operating leverage if the economy turns around”--meaning earnings growth could be extraordinary.

How Small Should You Go? If you believe that small stocks are starting a long climb--like the multi-year rise of the late 1970s and early 1980s--mutual funds make it easy to buy in.

Listed above are six funds that have respected records in the small-stock derby. Call a few of the funds and ask for prospectuses and annual reports. When you get the literature, take a look at what’s in the portfolios. You may be surprised at how differently the funds define a “small” stock.

The usual description of a small stock is one traded on the NASDAQ over-the-counter market. But in fact, the small-stock universe includes many New York Stock Exchange firms. Most money managers judge a company’s size by its market capitalization--the number of shares outstanding times stock price. And “small” can encompass firms of $50 million to $1 billion in market cap, depending on the fund manager.

The smaller a stock, the greater its volatility. As an investor, you must decide how much risk you can take: Do you want to own funds that hold the smallest of the small stocks (higher risk, but potentially higher return), or stick with funds that own “bigger” small stocks (usually safer stocks).

In reading prospectuses, a simple gauge of the relative size of a small-stock fund’s holdings is how many household names you recognize. The fewer names you know, the more you’ll have to trust that the manager is adept at finding those very small issues that are next year’s big stars.

A Sampling of Small-Stock FundsHere are six mutual funds that specialize in smaller stocks. All have ranked highly in performance the past year and/or the past five years. All are “no-load”--there is no fee to buy them. However, many of these funds charge fees ranging from 2% to 6% if you sell out within three years. Ask before you buy.

Fund/ Minimum Total return: phone number investment 5 yrs. Yr-to-date Kaufmann Fund 800-237-0132 $1,500 +117% +49% Keystone S-4 Fund 800-343-2898 $1,000 +91% +43% MFS Lifetime Emerging 800-343-2829 $1,000 NA +52% Montgomery Small Cap 415-627-2400 $5,000 NA +71% Prudent Speculator 800-444-4778 $1,000 NA +59% Scudder Development 800-225-2470 $1,000 +111% +42% Average small stock fund +74% +34%

Five-year returns through Sept. 30; year-to-date returns through Oct. 10.

NA: not available (fund hasn’t existed for five years).

Source: Lipper Analytical Services Inc.