A primer on small-cap stocks hitting record high

AP News
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Posted: May 04, 2011 5:24 PM

It's challenging to get a handle on where the economy is headed. The stock market rises on promising corporate earnings one day, only to slide on disappointing jobs data the next. Still, records are being set.

The most widely used benchmark of small-cap stocks, the Russell 2000 index, hit an all-time high on Monday, eclipsing a record set in 2007. It's slipped since then, but remains up nearly 143 percent from its low in March 2009, when stocks hit bottom during the financial meltdown.

By comparison the Standard & Poor's 500 is up 99 percent. That index, of the 500 largest stocks, remains 16 percent below its record level of October 2007.

Although the Russell 2000 represents a much smaller part of the overall market, that doesn't mean it isn't important _ just ask investors who've seen huge gains. Now, the question is whether it can last.

"We've had a really strong run, and normal volatility would suggest the market could cool off a bit," says Nathan Moser, manager of the Pax World Small Cap Fund. "But over the longer term, I think small-caps will continue to outperform."

Here are answers to common questions about the Russell 2000, why it's climbed so high, and whether the small-cap surge still has momentum:

Q: What stocks are in the Russell 2000?

A: The Russell 2000 includes 2,000 of the smallest stocks, based on their market capitalization. Small-cap stocks are typically defined as companies with a market value of $300 million to $2 billion. The current average market cap of the index is $1.4 billion. The five largest sectors represented are financial services, technology, consumer discretionary, producer durables, and health care.

That value of the Russell 2000 represents 8 percent of the total stock market. By comparison, the S&P 500 represents about 75 percent, which is why those stocks anchor 401(k) and other retirement accounts.

Q: Is the index still near its high?

A: The Russell 2000 closed Wednesday at 832.9 points, after hitting an all-time high of 868.6 on Monday. Last Wednesday, the index broke its previous record of 856.5, reached on July 13, 2007.

Q: Why has the Russell 2000 climbed so high?

A: Small-cap stocks tend to be among the first to rise when the economy rebounds. That's because these companies are more nimble operationally, and generally invest in their growth as a recovery gains momentum. Indeed small-caps came back faster than large-cap stocks when the recession ended, and as the market turned the corner.

Small-cap stocks have also benefited from low interest rates. Smaller companies are more likely to rely on borrowing, and low rates can really help a bottom line.

Q: How long have small-cap stocks been outperforming large-cap stocks?

A: Small-cap stocks have outperformed large-caps for most of the last 11 years. Their current dominance outlasts a 9-year small-cap run that started in 1974. Typically, small- or large-caps swap the lead every few years, rather than every decade or so.

Q: Can small-caps keep this up?

A: Many market pros say the small-cap advantage is about to end. They argue small-cap stocks have risen so high that they're unjustifiably expensive, considering the profits they're expected to generate.

Q: What are current risks for small-cap stocks?

They could be hit harder than large-caps if the economic recovery hits a dead-end, says Moser, the small-cap fund manager. Smaller companies offer fewer products and services, and have less cash on hand to tap if the economy skids.

In a down market, investors want to own larger companies, "because they usually have fortress balance sheets and the ability to weather the downturn," Moser says. "But when the economy is growing, small-caps are the place to be."

Another risk: Expectations that the U.S. dollar will remain weak as the federal government continues to struggle with debt. The weak dollar makes U.S. products more affordable to foreign buyers. That's crucial for fueling sales at big companies with foreign customers, but smaller companies are naturally less likely to sell overseas.

Finally, a rise in interest rates will hurt small-caps. With short-term rates near zero, there's nowhere to go but up.

Q: Why might the small-cap rally still have legs?

A: Small-caps could increasingly become buyout targets of bigger companies looking to dip into cash hoards that have grown to record levels. S&P 500 companies have $940 billion on hand, with nearly one-third of that stash accumulated since late 2008. Expect stocks of acquisition targets to surge when deals happen.

Q: Are there index mutual funds or exchange-traded funds that track the Russell 2000?

A: Yes. ETFs that track the index include the iShares Russell 2000 Index (IWM) and the Vanguard Russell 2000 Index (VTWO).

Of course, plenty of small-cap mutual funds hold many Russell 2000 stocks. If you're looking to hold a diverse group of small-cap stocks in a managed fund, consider those categorized as small-cap blend, or small-cap core.

Q: What percentage of an average investor's portfolio should be in small-cap stocks?

A: The Russell 2000 represents about 8 percent of the market's value, so that's a good threshold. Someone with above-average risk tolerance and a few decades until retirement might consider 10 to 15 percent. Around 5 percent is appropriate for someone near or in retirement. A risk-averse investor should limit small-cap holdings because they're more volatile than large-cap stocks.

Q: What else should investors know about small-cap stocks?

Although there may be dozens of Wall Street analysts following a large company's stock, small-caps could have limited or even no coverage. With less publicly available research, there's a greater chance that a small-cap's stock price doesn't accurately reflect the company's true prospects. That can present buying opportunities for fund managers, or individual investors willing to pick their own stocks

Also, don't expect dividend income. Smaller companies are more likely to plow cash back into their operations to fuel growth rather than share profits with investors.