Small Wonders

January 2007
 

Call it the five-year itch.

As soon as any type of investment outperforms the market for five years straight, a swarm of analysts, observers and commentators conclude that it’s time to pull up stakes and move your money elsewhere.

Lately, the pack mentality has focused on small-cap stocks, which have outgained large caps by about a two-to-one margin since 2001. There’s no shortage of opinions that investors should lock in profits and move on. One of the more popular destinations: the land of large-cap growth stocks.

Yet with many leading experts, including Northern Trust’s Chief Investment Officer Orie L. Dudley Jr., predicting continued growth ahead for the U.S. economy, investors might want to consider moving to a different corner of the small-cap camp — one where the horizon appears to be still relatively rosy.

Small-cap growth stocks, which have actually trailed the market since 2001, have several factors working in their favor.

“Historically speaking, small-cap growth stocks offer opportunities for greater and faster growth than more mature large-cap companies,” says Northern Trust’s Christopher D. Guinther, manager of the Northern Small Cap Growth Fund.

“They also tend to operate within very long cycles, which makes short-term predictions inadvisable. So it really makes sense to keep small-cap growth stocks part of a long-term asset allocation plan, especially now.”

Market trends point to growth
Among reasons that small-cap growth stocks may be poised to grow:

1. The valuation gap. To grasp how underappreciated small-cap growth stocks have been, consider how small-cap stocks have performed since 2001: In the five-year period ended Sept. 30, 2006, value stocks largely accounted for the rise of small-cap equities. The Russell 2000 Value Index notched a cumulative 118.87 percent return. By comparison, the Russell 2000 Growth Index posted a cumulative advance of 62.15 percent. The disparity has left small-cap value stocks with valuations near all-time highs and valuations of small-cap growth-stocks hanging near 10-year lows.
    

   “Based on current valuations, small-cap growth stocks should be a good place to be in the market for the next five years,” Guinther says.

2. Lowered expectations. In the wake of the recent multi-year rally, few believe small-cap stocks can keep climbing.
    

   “Low expectations may appear disappointing on the surface, but they tend to be a positive for stock prices,” Guinther says. “That’s because they’re easier to beat and the market likes to see companies beat expectations.”
    

   That might not be hard: Analysts predict a 14 percent increase in earnings for 2007. This is a modest threshold, considering the average mean, or midpoint, for annual growth rates in small-cap companies since 1979 is 23 percent per year.

3. A healthy economy. Economists predict continued, albeit slower, growth in the U.S. economy. And if the growth rate slows too much, the Federal Reserve has the ability to cut its key lending rate, a move that generally sparks economic activity.
    

   A healthy economy and low lending rates are helpful to growth companies, which are priced in relation to future earnings potential.
    

   

   “If growth expectations are low but still positive and interest rates are falling or expected to fall, that can set the stage for small-cap outperformance,” Guinther says.
    

   “Of course, we’re mindful of the possibility of a recession, which occurs when the economic growth rate turns negative. If that were to happen, all stocks would suffer and riskier assets, such as small-cap stocks, would probably be hit harder. But again, if investors keep a long-term perspective, such a period could present even more of an opportunity.”

Nimble companies tend to thrive
The beauty of small-cap growth stocks lies in the flexibility of each company to effectively address a market need.

Without large bureaucracies or costly legacy systems weighing on the decision-making process, a small outfit can identify a niche, develop an attractive solution and get it to market in a fraction of the time it would take a large firm.

While risks certainly exist—small caps may have limited resources or potentially less experienced management, so one misstep can prove quite problematic for a small company — however, the potential is great.

For example, a Northern Funds Small Cap Growth Fund holding, Middleby Corp., manufactures ovens for commercial and industrial uses.

While serving what would appear to be a stagnant corner of the marketplace, Middleby has consistently integrated innovative products and features into its ovens that appeal to managers of large-scale baking operations. In turn, Middleby’s revenues have jumped an average of 34 percent a year since 2001 and its profits have leapt 61 percent annually over the same time period. As of Dec. 31, 2006, Middleby Corp.* comprised 1.02% of the Fund’s portfolio.

“Small-cap stocks can quickly attack market segments that bigger companies won’t even think about moving into,” Guinther says. “So many small-cap companies have the opportunity for substantially faster growth rates than mid-and large-cap-sized companies, even in rather mundane industries.”

The tradeoff for a potentially higher growth rate is heightened risk, as a small company’s narrower focus provides less room for error. To compensate for this higher risk level, it’s prudent to broadly diversify small-cap holdings. For instance, Guinther maintains a well-diversified portfolio of about 115 stocks.

“Buying a single small-cap stock is much more risky than buying a single large-cap stock, such as Microsoft*,” Guinther says. “By investing in a variety of companies across a large cross-section of industries, we’re reducing the risk that any single holding has for investors.”

A strategy worth exploring
While acknowledging the impressive performance of small-cap stocks since 2001, it’s important to take the five-year itch with a grain of salt.

“No one can predict market cycles,” Guinther said. “But within any long-range strategy, small-cap growth stocks certainly deserve a role.”