Those swingin’ small caps

Benj Gallander and Ben Stadelmann
Friday, September 26, 2003

Investors are finally getting some relief when they open those monthly statements. But while bullish sentiment is at extremely high levels, few realize — even those observers in the “feel good media” — just how broad and powerful the rally has been.

That’s because popular measures such as the S&P 500 index, the Dow Jones Industrial Average, and Canada’s S&P/TSX (run by Standard & Poor’s) are — despite their decent performance thus far in 2003 — actually running well behind the broader market.

The real muscle has been in small-capitalization stocks. Impressed with the Nasdaq’s 26.5 percent gain? Well, the Russell 2000 is better yet, up a sizzling 29 percent. The S&P 600 index of small-caps is up 21.4 percent, far better than its large-cap big brother, which has gained 14 percent this year.

This pattern is exactly the opposite of what happened in the late 1990s, when the large-cap glamour stocks handily outperformed the small fry. Ken Fisher, head of the $12 billion Fisher Investment fund and a Forbes magazine columnist, put this ascendancy succinctly in a 1998 article, “Dance of the Elephants.” He suggested that investors stick to the biggest of the big — firms with a minimum of $60 billion in market capitalization. His favourite? General Electric, “because it’s the biggest.”

One explanation for this phenomenon was the increasing dominance of the equity markets by institutional investors throughout the 1980s and 1990s. These managers tend to shy away from thinly traded stocks and look for well-analyzed companies that are liquid — and large — enough to absorb massive amounts of capital.

Index funds, which are weighted by market capitalization, also funnelled money into the giants, and in a self-reinforcing process, the more they grew, the bigger the slice of new money they sucked up.

At the same time as Fisher was explaining his rules of the jungle, his fellow Forbes columnist Mark Hulbert disagreed, predicting that the trend would eventually revert to the historical pattern of superior small-cap performance over the long haul: “As more investors come to realize that mutual funds as a group cannot outperform the market, I think there will be a shift back to individual stock ownership.”

We’d differ a bit with Hulbert on this point. It’s not so much relative underperformance by mutual funds that is the problem — it’s the experience of seeing these behemoths chew up their savings that has turned people off. Individuals scarred by awful returns are now casting about for ways to do better on their own, and are more willing to take stakes in smaller enterprises.

And that makes sense, because the low liquidity that hamstrings the pension fund manager is not a concern to the patient small investor. True, it means that bid/ask spreads need to be scrutinized carefully, and limit buy orders need to be prudently placed. But in our experience, the out-of-favour small-cap that is tricky to buy is easy to sell when it enjoys a flush of liquidity as the company returns to favour.

Elephants might do the rumba, but mice can swing.