Why Smaller Hasn’t Meant Better This Time Around

Bigger meant richer on Wall Street in 1995, as blue-chip stocks performed better than their small- and mid-size rivals for a second year in a row. What’s more, the inability of smaller stocks to grab the lead in a market arguably tailor-made for them--with interest rates falling and corporate earnings growth overall decelerating in ‘95--isn’t stoking optimism about their ability to steal the performance crown in 1996. The start of the new year on Tuesday had an all-too-familiar ring for frustrated small-stock owners: The blue-chip Standard & Poor’s 500 index jumped 0.8% while the Russell 2,000 small-stock index added just 0.3%, although that was still enough to edge the Russell to a record high.

In 1995 the S&P; 500 rocketed 34.1% while the Russell gained 26.2%. And in 1994, a down year for stocks generally, the S&P; slipped just 1.5% while the Russell fell more than twice as much, off 3.2%.

Of course, some investors might consider arguments about market “leadership” in 1995 to be so much hairsplitting. The Russell index’s 26.2% rise was still its best since 1991. And the average small-stock mutual fund beat the Russell for the year, rising 31.8% on average, thanks to many fund managers’ heavy ownership of technology stocks.

But small-stock funds’ relative performance eroded sharply in the fourth quarter with the reversal in tech stocks. The Lipper small-stock fund average gain was neck-and-neck with the S&P; 500 at Sept. 30, with each up just under 30%. Then blue chips ran away with the race in the final three months of the year.

On Wall Street, where every percentage point counts, two straight years of under-performance by smaller stocks may wind up causing more money managers to divert investment from small stocks to larger stocks, analysts say. That’s because small stocks’ performance cycles have historically run for extended periods. They tend to run strongly ahead of blue chips for a long time--as from 1991 through 1993--or well behind for a long time.

Some small-stock proponents, however, argue that the game in 1996 isn’t big versus small but rather a more intensified version of investors’ usual obsession: finding good corporate earnings growth, which is what ultimately drives stock prices.

“I think the market will become much more selective when it comes to earnings,” says Beth Dater, manager of the Warbur Pincus Emerging Growth stock fund in New York.

That’s another way of saying that savvy and nimble stock pickers should do well in 1996 no matter which size of stock they’re shopping for. The question is where the good-earnings-growth pickings will be more visible--among smaller companies, which make up the bulk of traded stocks, or among the relative handful of well-known large stocks such as Coca-Cola, drug giant Merck and conglomerate General Electric.

Louis Navellier, manager of the Navellier Aggressive Small-Cap stock fund in Incline Village, Nev., steered his $100-million fund to a 43.9% gain in 1995. But Navellier concedes that “there’s a real leadership crisis in the Nasdaq market now,” where most smaller stocks trade.

Smaller technology and telecommunications stocks have fallen out of favor as more of those companies have warned of weaker-than-expected earnings growth ahead, Navellier notes. And Wall Street analysts now are lowering earnings estimates at a faster rate on smaller companies in other industries as well, he says.

“I really don’t like what I see. I think we’re in a real dicey market,” Navellier says. The underlying problem is the weaker U.S. economy, which is naturally affecting companies’ sales and thus their earnings. “The economy has tailed off a lot faster than people thought,” Navellier says.

*

Of course, that will be bad news for many blue-chip multinational companies as well. Indeed, the overall earnings growth rate of the S&P; 500 has been ratcheting lower for the past two to three quarters, meaning the year-over-year quarterly percentage gains that big companies report grew less robust as 1995 wore on.

But in periods like last year--with interest rates falling and spectacular earnings gains harder to find--investors have historically been more inclined to chase smaller stocks. That trend finally began to emerge in the third quarter of 1995, when the Russell 2,000 index outpaced the S&P; 500.

By the fourth quarter, however, the blue chips stole the spotlight back again.

Claudia Mott, small-stock specialist at Prudential Securities in New York, says many investors’ continued preference for big-name stocks is logical given the U.S. economy’s sluggishness. “The fact that smaller companies are so domestically dependent is a real bummer right now,” she says, because investors assume smaller firms’ earnings will inevitably suffer with the U.S. slowdown.

On the other hand, multinational blue chips at least offer the hope that they can offset weaker U.S. earnings growth with faster earnings growth from overseas business.

In addition, blue-chip companies have greater financial wherewithal to support their share prices if they begin to sag, either via stock buybacks or by launching yet another restructuring--as AT&T; Corp. did on Tuesday, driving its stock up 4% by announcing another severe round of job cutting.

Still, investors should remember that because most stocks are by definition small (the usual definition is a company whose market capitalization is under $1 billion), ignoring smaller issues altogether ignores a lot of potential. Over the long run smaller companies grow faster than bigger companies, and over the long run small stocks have beaten big stocks.

But for 1996 small-stock fund owners will need strong conviction that their manager has a great eye for near-term earnings growth--and a willingness to pull the trigger if stocks disappoint.

Navellier, despite his concerns about the market overall, maintains that he’s still very much confident in the prospects of the small companies he owns, including computer networking firm Ascend Communications, oil-services firm Reading & Bates and gambling company Grand Casino.

Dater, whose fund was up 46.2% in 1995, remains bullish on such names as biotech firm Gilead Sciences, mutual fund company T. Rowe Price and temporary-help agency On Assignment.

She also warns that fans of blue-chip stocks may be far too optimistic about those companies’ ability to keep earnings on track, especially if the U.S. dollar continues to strengthen--which would be a natural depressant on multinationals’ earnings.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Big vs. Small

Small-company stock indexes have lagged the performance of blue-chip stock indexes for two consecutive years, after sharply outperforming the blue chips from 1991 through 1993. Annual changes in the Russell 2,000 small-stock index and the Standard & Poor’s 500 blue-chip index:

Russell: 26.2%

S & P: 34.1%

Source: Times research