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Despite Rate Hike, Future Is Bright for Small-Cap Issues

THE decision by the United States Federal Reserve Board Tuesday to hike short-term interest rates once again focuses attention on one especially important sector: ``small cap'' companies. Small capitalization stocks set a new record on Wall Street last week, before this latest increase in the federal funds rate, which is the interest banks charge each other on overnight loans.

Will this latest rate hike - the second in two months - derail small company stocks? It didn't on Tuesday.

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The growing consensus here is that small-company stocks - after a sluggish start - will turn in a good earnings performance in 1994. And that in turn should mean additional jobs for US workers.

Small capitalization companies are the hundreds of modestly sized firms that are listed in such stock indexes as the NASDAQ composite index, the Russell 2000 index, and the Wilshire Small-Cap index. These companies are part of the backbone of the US labor force, employing hundreds of thousands of workers between them. Throughout much of the 1980s, these companies created more jobs than the blue-chip companies that make up the Dow Jones industrial average.

The well-being of the small-cap sector, experts say, is essential to the well-being of the overall economy. But can its upward price performance in recent weeks be sustained in light of climbing interest rates?

According to a study by Claudia Mott, a small-cap expert with Prudential Securities Inc., an investment house, small-cap stocks failed to outperform large company stocks in the month of January in only six of the past 68 years: 1929, 1939, 1952, 1973, 1987, and 1989. Unfortunately, she notes, small-cap stocks went on to underperform large-cap stocks for the entire year in five of those same six years. The exception was 1939.

This year again January was a slow month for small stocks; the Dow led all market averages with a return of 6.2 percent; the Russell 2000 rose 3.1 percent, and the Wilshire Small-Cap index gained 3 percent. But by early March small-cap issues - led by technology stocks - had hit their stride. On March 17 the Nasdaq composite index shot up to 803.85 points, up from its previous high for the year of 800.47 points on Jan. 31.

BUT earlier this week the NASDAQ index slipped a few points, due to concerns over rising interest rates.

Still, many small-cap experts remain optimistic. ``Small-cap [companies] remain less vulnerable to rising interest rates over time than larger companies,'' says John Morris, an analyst with Prudential Securities. ``A lot of these companies are not burdened by debt, and so they do not have to worry about paying higher interest rates. Small companies are also leaner. They are not layered with bureaucracies and a lot of overhead, so they tend to operate a little more efficiently.''

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Dennis Jarrett, chief technical analyst for the investment house Kidder, Peabody & Company, says that small to mid-sized firms represent the ``leadership'' segment of the stock market for the ``next two to four years.''

Historically, he says, the small to mid-sized company segment tends to outperform the broader market in cycles of about six to seven years. This particular cycle has run three years already; thus, he argues, the sector should do well for another three to four years.

One factor propelling an interest in small to-mid sized companies, he argues, is strong demand from overseas investors. Jarrett sees the possibility of new streams of cash available for investment in Wall Street in the next few years.

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