Can the small-cap stock rebound last?

[February 20, 2012]  BOSTON (AP) -- Optimism has returned to the market. And the clearest evidence is the rebound of small company stocks.

After being beaten by large-caps last year, more nimble small-caps are back in the lead. They rewarded investors with their best January since 2006. It's one sign that investors are getting more comfortable and not rigidly avoiding risk by sticking with the market's biggest and most stable companies.

How long the comeback can last is a pressing concern, because small-caps are the market's proverbial canaries in the coal mine. When trouble hits, these frequently volatile stocks typically feel it first and suffer deeper losses than bigger stocks. On the flip side, small-caps are usually early leaders in a sustained market rally.

Ask small-cap investing specialists whether this turnaround has run its course and you may get very different answers. One crucial factor: whether the Federal Reserve is gearing up for a third round of quantitative easing. Fed officials recently discussed launching another bond-buying program. The aim would be to boost the economic recovery by making borrowing cheaper and encouraging risk-taking through investments in stocks. Small-caps are among the highest-risk stocks and would benefit from another round.

The need for market stimulus hasn't been great lately. Just a couple months into the year, a small-cap index, the Russell 2000, has posted a return of 10 percent. The Dow Jones industrial average is up half that much, while the Standard & Poor's 500 has gained 7.1 percent.

Below are two contrasting views on the small-cap rebound. They're from managers of mutual funds specializing in small-caps, generally defined as stocks with market values of $300 million to $2 billion. Both funds are top performers. Their average annualized returns over the last five years place them within the top 2 percent of their small-cap value peers.

The more cautious outlook is from Jayme Wiggins, lead manager of Intrepid Small Cap (ICMAX). More than a third of the fund is held in cash, a defensive position in line with Wiggins' dim outlook.

Taking a more optimistic view is Adam Peck, co-manager of Heartland Value Plus (HRVIX). He believes small-caps will outperform large-caps. That's because profit margins at larger companies have nearly returned to pre-recession levels, while smaller firms still have a ways to go.

Here are excerpts from recent interviews:

Q: How do you explain this year's small-cap comeback?

Wiggins: The economic and company-specific news hasn't been great. We suspect many professional investors have been buying in anticipation of another quantitative easing announcement. We don't play that game. Eventually, we think others will regret participating in yet another Bernanke risk trade.

Peck: Investors have been warming up to risk and to small-caps. Over the last three years, we've had phases of risk-on, risk-off. It was risk-on through last July, and then the European debt crisis came to head and it was risk-off. Then Europe seemed to get its act together temporarily and it was risk-on again toward the end of the year. That risk-on trade has continued this year and I think it will continue to help small-caps.

Q: Are small-caps good investments now, compared with other segments of the stock market?

Wiggins: We don't make short-term market predictions. Small-caps continue to be priced at a premium to larger companies. Ultimately we expect that premium to diminish. We're having difficulty finding cheap small caps and we've tried to position our portfolio defensively with companies that are less sensitive to changes in economic growth.

There will always be opportunities to take advantage of market volatility to purchase misunderstood smaller-cap names. The businesses we own are undervalued, but in my opinion, they are the exception in the small-cap universe. If you asked me whether I would rather own the S&P 500 or Russell 2000 index for the next five years, I would choose the S&P 500.

Peck: Small-caps are a good place to be because they've got more room for profit growth than large-caps. The ratio of net profits to revenues at large companies averaged 10.8 percent at the end of last year. That's nearly back to where the average was in 2007, when large-cap profit margins were at their historic peak of 11 percent. Smaller companies averaged 5.4 percent at the end of December. There's still quite a ways to go before they return to their peak of 6.8 percent, reached in 2006.

Profit margins at larger companies are approaching pre-recession levels because they were able to cut costs faster than small companies.

Even in a period of slow economic growth, we can find small companies that are growing rapidly. That's more difficult for the mega-caps (the biggest stocks, such as Exxon Mobil and General Electric) that are more closely tied to the general health of the economy.

Q: Is there any particular segment of the market you're looking to invest in now?

Wiggins: We don't segment our portfolio by sectors, or by value versus growth stocks. However, the types of companies we invest in are generally strong generators of free cash flow.

Peck: We like small banks. Banks in general have been a hated sector since the financial crisis. But for the most part, small community banks were not swept up in all the bad stuff the larger guys did. But the investor sentiment has been negative for small banks, just as it has for large ones.

Because the sentiment has been so bad, small banks have been trading at valuation levels that have reached the lowest in decades, on a price-to-book basis. They're currently under-earning versus their potential. Banks' return on assets usually runs at around 1 percent and the vast majority of banks are earning under that. Everything is inherently cyclical and someday they will return to historic averages.

[Associated Press; By MARK JEWELL]

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