Small Caps Pick Up the Pace

Stocks of small companies look ready to catch up with the blue chips

Small-company stocks are back in the Wall Street limelight, often outpacing their large-company rivals, and that focuses attention on mutual funds that buy them.

On Monday, for example, the Russell 2000 small-company index jumped 0.57 percent, even while the Standard & Poor's 500 index of large company stocks fell 0.37 percent.

That ripples into mutual fund results: "Small-cap" funds jumped 1 percent in the past week, compared with a drop of 0.77 percent for growth-and-income funds, oriented toward blue-chip stocks.

"There's definitely a shift to small and mid-cap companies under way," says Rao Chalasani, chief strategist at Everen Securities in Chicago.

A key reason is the very success earlier this year of their blue-chip brethren.

"Valuation levels are just very high" for many blue-chip companies, Mr. Chalasani says.

Whether the small caps have staying power is another question.

During this bull market, analysts have sometimes given the nod to small caps, only to see them fade from the pace set by the huge firms of the S&P 500 index and the Dow Jones Industrial Average.

But that may be changing, as more investors worry about high stock prices among the blue chips.

Peggy Farley, managing director of AMAS Securities in New York, adds that the new federal budget deal also helps the small caps by lowering the capital-gains tax on profits.

Many investors may now see an advantage to small-company issues that appreciate in value but pay minimal or no dividends. That's because dividends (a hallmark of most blue-chip firms) are taxed at a significantly higher rate than capital gains.

The new tax law will definitely boost small-cap stocks, says David Sterman, assistant director of research at Individual Investor magazine. Blue chips look tired, he says.

Mr. Sterman likes technology-oriented small-cap funds, including Seligman Communications and Information Fund, up 40 percent this year, (800-221-2450) and Fidelity Select Electronics Fund, up 44.88 percent year-to-date (800-544-8888).

Small-cap funds buy stocks of companies valued well below $1 billion in market capitalization - the number of shares times their stock price. Small-cap firms often have a capitalization between $250 million and $500 million.

Mid-cap funds typically favor market capitalizations between $500 million and $1 billion.

So far this year, small-cap funds with a "value" style have outperformed small-cap "growth" funds, according Morningstar, a financial information firm in Chicago.

Value funds look for companies whose shares sell at a discount to their true value. Growth funds, by contrast, look for above-average growth in profits.

Chalasani at Everen Securities urges his clients to look for small US companies - while also turning to Europe and Asia to find attractive large companies. Overseas blue-chip firms have lower valuation levels than their US counterparts, he says.

Over time, small-cap firms tend to be more volatile than larger companies. They often depend on one or two products, and have trouble attracting financing. For most individual investors, mutual funds lessen the the risk in this segment.

Some observers question whether small- and mid-cap funds are finally making a true comeback.

Sheldon Jacobs, who publishes The No-Load Fund Investor, expects a resurgence for small-cap funds but is not prepared to say it's started. In fact, Mr. Jacobs recently dropped two small-cap funds, Oakmark International And Founders Passport, from his best-buy listings.

Index funds offer an easy way to invest in the entire segment. Dreyfus (800-645-6561), for example, just added a SmallCap Index Fund to a roster that already includes a MidCap Index Fund. The new fund, up 5.18 percent in July, will mirror the S&P SmallCap 600 index, up about 19 percent for the year compared with 23 percent in the S&P 500 index.

The Dreyfus MidCap Index Fund is up 23.3 percent for the year through Aug. 25, compared with 22.58 for the S&P MidCap 400 index.