Small-Stock Fans Keep Fingers Crossed

Small stocks look set to sizzle.

That's what many analysts say. The only problem: They said the same thing last year and were wrong.

Ah, but the "small-caps" might really have a shot at top performance in 1998, says Peter DiTeresa of Morningstar Inc. in Chicago.

These companies, typically valued at less than $500 million in market capitalization (share price times number of shares), are far less export-oriented than large companies, he notes.

That insulates them somewhat from Asia's financial crisis, says Mr. DiTeresa, who tracks small-company mutual funds. The Asian turmoil has already deflated earnings forecasts at many big companies.

Still, small-caps hardly seem a shoe-in. In an uncertain market, they often fare poorly.

They got clobbered in the fourth quarter of 1997. And so far this year, the Russell 2000 small-cap index is down 1.6 percent, versus a 1 percent gain for the Standard & Poor's 500 index.

January flop

Another ominous sign: January is when small-company stocks are supposed to explode with hefty returns and market glory; but the "January effect" has fizzled - not just last month but for the past four years.

Claudia Mott, a small-cap analyst at Prudential Securities, notes that in a majority of years when small-caps failed to spark a rally in January, they have gone on to underperform the market for the full year.

Last year, small-cap stocks, nonetheless, broke free and sailed into a rally in late April.

But many analysts caution about a change in conditions for 1998.

Corporate earnings gains will be harder to come by this year, says Arnold Kaufman, who follows the market at Standard & Poor's Corp.

In that climate, investors may find small stocks less appealing than large ones with strong market share and recognized names.

Investors should look for small-cap companies "leveraged to the domestic economy," says Rao Chalasani, chief market strategist at Everen Securities in Chicago. He believes small-caps may come back into vogue in the next few months.

But Mr. Chalasani remains wary of firms that face competition from Asia. Prices on imports from Asia will drop, cutting into profits of American producers.

And weak currencies raise prices for Asians shopping for US exports. Technology small-caps have been hit especially hard for this reason, albeit with a modest rebound recently.

Value beats growth

That helps explain why "value" investing has outpaced "growth" among the small caps, Di Teresa notes.

A value investor typically looks for companies priced lower than competitors - often with low price-earnings ratios. Growth investors look for such characteristics as strong earnings growth and stock-price momentum.

For technology stocks, much of that momentum is sapped by the Asian slowdown.

"The advantage that small-cap value funds have right now is that they are in less-volatile [sectors] than growth companies," Di Teresa says.

Last year, small-cap value funds gained about 28 percent, versus 14 percent for small-cap growth.

Whether you favor value or growth, analysts say you should probably give small-caps a place in your portfolio - perhaps 10 to 15 percent - if only for diversification.

Di Teresa prefers small-cap value funds. But long-term investors, who will be holding their funds (or individual stocks) five years or longer, should not shy away from growth, he adds. The key is to pick stocks and mutual funds that have promise of solid performance over time.