No winning streak lasts forever. Not in sports. Not at the casino. And definitely not on Wall Street. That lesson may soon be clear to investors with large holdings of small-company stocks.
Barring a rally in the final six trading days of the year, a monumental run for shares of tiny companies will come to a halt. The Russell 2000, an index which tracks stocks valued roughly from $250 million to $2.5 billion, is down 2.6 percent in 2007. If the widely followed small-stock benchmark finishes in the red, it will mark its first negative year of performance since 2002.
What’s more, the Russell 2000 this year is 5.5 percentage points behind the Standard & Poor’s 500, which tracks large-company stocks valued at as much as $500 billion. If the Russell can’t overtake the S&P, it will mark the first time since 1998 that small-cap stocks have posted lower returns than large stocks.
That would end an eight-year streak of outperformance for small stocks, second only to a 10-year run from 1974 through 1983, according to Ned Davis Research.
The death of the streak is significant because it could signal a long-term performance shift is under way that would favor large stocks over small ones, notes Ernie Ankrim, chief investment strategist at Russell Investments. Periods of market outperformance tend to last for years. Once the hot style fades, the new market leader enjoys its own multiyear run. “These market cycles are not short-lived,” he says.
Small company shares face greater headwinds than bigger stocks, because they are:
– More dependent on domestic economy. Small firms do the bulk of their business in the United States, which now is a double-barreled negative. A more domestic focus means profits suffer more than big companies when U.S. economic growth is slowing. And small firms can’t capitalize on the hot economic growth around the world in places such as China and India.
“Smaller companies tend to be more sensitive to the economy due to a lack of global footprint,” says Chris Colarik, manager of Glenmede Small Cap Equity Fund.
– More expensive than big caps. “Valuations are less compelling for small stocks,” says David Chalupnik, chief equity officer at First American Funds. The Russell 2000 sells at 24 times trailing earnings, versus just 17 times for large stocks, says Russell Investments. Small stocks also are selling at pricier multiples, compared with large stocks on ’08 profit estimates.
Meanwhile, expectations are too high. Chalupnik says analysts predict 30 percent earnings growth for small stocks in ’08. He expects growth to be flat or negative.
The upshot? “Large caps will outperform again in ’08,” says Nick Raich, research director at National City.
