January 05, 2006, 8:57 a.m.
Small-Caps Are the Place To Be
Think twice before handing more of your savings to the big-money managers.

Professional investors are still pining over the weak performance of large-cap stocks while calling for an eventual rally in this category of big names. Of course, the great majority of these professionals shepherd billions of dollars in equity investments, so all they can do for their clients to justify their high fees is to play musical chairs among these big-cap names.

The irony in the world of professional investing is that the big guys with all the marketing muscle and slick sales forces cannot overcome the fact that big stocks, the only game in town for big money, haven’t been performing well relative to smaller stocks. For example, the S&P 500 is essentially flat, rising only 0.64 percent per year for the five years ended November 30, 2005, while the S&P MidCap 400 and the S&P SmallCap 600 are up 10.07 percent per year and 13.57 percent per year, respectively, over the same time period. For the last ten years, the S&P 500, with a push from indexing, is up 9.28 percent per year, while the S&P MidCap 400 has increased 14.25 percent per year. (The S&P SmallCap 600 was not around for the entire time period.)

When you get into the really big names, the data deteriorate. The S&P 100, the 100 largest stocks by market capitalization (and 55.2 percent of the S&P 500), has actually declined by 2.09 percent per year over the past five years. Remember, this five-year period occurs after the technology boom and reflects a period when many of the so-called riskier small companies should have done worse, not better.

The delirium surrounding the initial public offering of Google and the subsequent price performance of the stock is another example of how the big money managers find themselves in a limited world for making above-average profits. Since Google started out as a big-cap stock (at IPO, the market cap was about $25 billion; today it’s $127 billion), it provided a reason for the big-cap stock lovers to marvel at the company and the related performance of the stock. However, the downside for many big-cap managers this time around is that the gales of creative destruction are blowing harder than usual, with the drug and auto companies, the old big-cap names, becoming thorns in the side of big-cap performance. One Google can’t make the difference.

Investors may think twice about handing more of their savings to the big-money managers who have little flexibility in adding value. These “mega-tanker” investment firms have little ability to turn left or right when the need arises, and they can’t invest enough of their money in small- and mid-cap stocks to make a difference. A better alternative might be to seek out smaller investment advisors who can and do provide meaningful access to the universe of small- and mid-size companies. But one may ask, “Why invest in the smaller-cap sector since it has done so well for the past five years? Isn’t it due for a slide?” Here’s why the sector still makes sense:

Big-cap companies have never been wealthier. As the better small- and mid-cap companies emerge, big companies will spend some of their wealth on acquiring these companies. This is a great exit strategy for small- and mid-cap investors.

The mid- and small-cap universes are constantly changing, with the good companies going up and the bad companies going down. By actively managing a portfolio to hold the winners and sell the losers, investors should be able to add value to index performance. Since there is less efficiency in this segment of the market, thoughtful analysis should produce better results than trying to outsmart 15 analysts who are all recommending Microsoft as a great company but making no money in the process.

Investors who choose smaller investment advisors won’t be constrained by being forced to sell their winners. Imagine what would happen to a money manager who held a large position in a stock that did extremely well? Here is an example:

One of my favorite stocks has been Hansen’s, a small beverage company that has done very well in the manufacture and sale of energy-related drinks. While the big boys are fretting over the performance of Coca Cola and Pepsi, Hansen’s has been benefiting from strong demand for their specialty beverages. One seldom hears the name Hansen’s on the network finance shows because it is a small company with a market capitalization of only $1.8 billion. Of course, none of the big guys can capitalize on Hansen’s because of its size; they just can’t buy enough. When I compared the performance between Google and Hansen’s I found the results interesting. Since Hansen’s has been around a lot longer than Google, I compared the performance of these two stocks from the time of Google’s IPO to the present, and I was surprised to see that Google rose 309 percent since inception while Hansen’s climbed 615 percent over the same time period.

Some investment managers are constrained by being able to hold only 10 percent of a position. Once appreciation takes a stock beyond that level, a planned reduction in that holding takes place. For Hansen’s, investors would not be able to fully benefit from the enormous rise in the stock price if they hoped for a big gain from the big guys.

The large 1990s move in the S&P 500 is probably over, given the trillion-dollar implementation of indexing over the past 15 years. As a result, investors may very well find that investing in smaller companies — even the less-than S&P 100 companies — will prove more rewarding than investing only with the big-cap managers who can only espouse the benefits of big-cap stocks.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.

*   *   *

YOU’RE NOT A SUBSCRIBER TO NATIONAL REVIEW? Sign up right now! It’s easy: Subscribe to National Review here, or to the digital version of the magazine here. You can even order a subscription as a gift: print or digital!