Why some small caps stay upright amid whitecaps

When it comes to domestic stock funds, small caps, particularly small-cap value funds, have shown strength since 2000, when the stock market shifted out of go-go growth mode.

Unfortunately, small-cap returns may prove harder to come by during the months ahead, now that scores of small investors and portfolio managers have bought into the small-cap universe – in effect, pushing up their price.

One result of the race to buy in: Many of the hottest small-cap funds have had to close their doors to new investors. Cases in point: the popular Wasatch Small Cap Value Fund and the Fidelity Low Priced Stock Fund.

And despite those two years of solid performance, small caps have taken some hits. For the first six months of this year, they posted gains in only one month – March – and slipped into negative territory in the other five, according to information firm Morningstar, Inc., in Chicago.

Their worst month this year: June. The category was down just under 6 percent. Still, most market analysts are not yet ready to throw in the towel.

"Small-cap funds should continue to do well, given their lower valuations compared to other fund categories, such as large-cap funds," says Dan McNeela, a Morningstar analyst.

If small caps have been down, they have been down less than most other stock categories. Moreover, analysts note that small-cap funds tend to make gains for cycles of around five years. If that proves true, small caps should see at least two more years of decent performance.

In looking at small-cap funds, it is important to note that the category really has two major components. Small-cap value funds, up more than 4 percent on average for the year to date, according to Colorado-based information firm Lipper Inc., and small-cap growth stocks, which are struggling – as are most growth categories – and down more than 16 percent in 2002. Blends of value and growth also exist.

The market capitalization "break point" that qualifies firms for inclusion in "small-cap" funds varies. Generally, small-cap funds include shares in small companies with assets ranging from $250 million to $1 billion.

Companies with assets of less than $250 million, the very smallest public firms, are usually considered "micro-cap" firms. Since the small firms included tend to be more domestic than global, they avoid many of the currency and geopolitical gyrations that can imperil returns from giant US export-oriented firms.

One new trend, says Mr. McNeela: Many small-cap value funds are starting to buy into growth companies in such sectors as technology and healthcare.

Sheldon Jacobs, editor of the No-Load Fund Investor, says investors should continue to have exposure to small-caps. In his database of 105 small caps, he finds 30 up for the year, some of them substantially, such as Eclipse Small Cap Value (16 percent) and Babson Enterprise (14 percent). "Eight are up in double-digit territory," he notes.

Mr. Jacobs would keep 60 percent of his small-cap exposure in value funds and 40 percent in growth, and reverse that balance when growth resumes. He thinks that will happen sometime in the next year or so.