Small-cap Value Stocks Buck the Bear Market

By Cathy Smart
Analyst, mPower

In This Story Small-cap Value Defined Small-caps — Value vs. Growth Small-cap Value vs. Large-cap Finding a Fund Active vs. Passive Management Picking a Fund — Five Tips

Your retirement portfolio has declined by 40 percent over the past year. In 1999, when the market was going wild, you parked your investments in large-cap and technology "growth" stocks. Who would have thought the boom would end?

Well, the boom did end. In 2000, the market went down almost 11 percent, as measured by the Wilshire 5000, an index that measures the performance of all U.S. stocks. And through the first quarter of this year, that index was down another 12.3 percent. Consequently, most people have seen the value of their retirement accounts drop substantially. But even in this down market, one asset class still managed to perform well and, as part of an investment portfolio, could have stemmed the bloodletting created by those growth holdings: small-cap value.

minute: read this article at a glance.

Technical Terms Capitalization Growth stock Price/earnings ratio Small-cap value stocks Style Value investing

Small-cap Value Defined

Small-cap companies have market capitalizations below $1.5 billion. (Market capitalization is the share price of a stock multiplied by the total number of shares outstanding at a given time.) These stocks can be divided into two groups: small-cap value and small-cap growth. What's the difference?

• A small-cap value stock is one that is undervalued when compared to its historical stock price, its industry peers, or the average small-cap stock. It also typically has a lower price-to-earnings ratio (P/E) than the average small-cap stock.
  • Example: IHOP Corp., which operates International House of Pancakes restaurants. At the end of 2000, IHOP's market capitalization was $434 million. Its P/E was 12.6 compared to the average small-cap stock's P/E of approximately 20.
  • IHOP's performance in 2000? Up 30 percent.
• Small-cap growth stocks are those that are expected to have above-average earnings growth. Small-cap growth fund managers may be willing to pay a high price for this growth, so the P/E ratios of small-cap growth stocks tend to be higher than the P/E of the average small-cap stock.
  • Example: Radiant Systems, a company that manufactures computer systems. At the end of 2000, Radiant's market capitalization was $568 million. Its P/E was 47.7 compared to the average small-cap stock's P/E of approximately 20.
  • Radiant's performance in 2000? Down 23.5 percent.

Small-caps — Value vs. Growth

Knowing about these two asset classes is important precisely because they can potentially perform differently from each other. In fact, the recent divergence between the performance of small-cap value and growth stocks is remarkable, as evidenced by the numbers below. For the year ending Dec. 31, 2000, small-cap value stocks drastically outperformed their small-cap growth counterparts.

	Small-cap value stocks	Small-cap growth stocks
1999	-1.49 percent	43.09 percent
2000	22.83 percent	-22.43 percent
	(Small-cap value stocks shows returns for the Russell 2000 Value Index.)	(Small-cap growth stocks shows returns for the Russell 2000 Growth Index.)

These numbers show us that small-cap growth stocks dominated small-cap value stocks in 1999, but in 2000, small-cap value stocks started to recover. For the year ending Dec. 31, 2000, small-cap value stocks crushed their small-cap growth counterparts.

"If you didn't hold any small-cap growth stocks in 1999, you missed out on some nice returns. And if you didn't hold any small-cap value stocks over the past year, your portfolio may have dropped more than it had to." — Cathy Smart, senior analyst at mPower Advisors, L.L.C.

The numbers also demonstrate that markets can change drastically over a short period of time. If you didn't hold any small-cap growth stocks in 1999, you missed out on some nice returns. And if you didn't hold any small-cap value stocks over the past year, your portfolio may have dropped more than it had to.

Small-cap Value vs. Large-cap

You might recall that in 1999, large-cap growth stocks had a great year. Intel, for example, was up 39.1 percent in 1999. But the markets turned around in 2000, causing many large-cap growth stocks to decline (Intel was down 26.9 percent in 2000).

And what about large-cap value stocks? They certainly fared better than their large-cap growth counterparts during this slumping market, but they didn't even come close to performing as well as small-cap value. When looking at the performance of large-cap stocks as one group (combining both growth and value stocks), we can see that small-cap value left its large-cap peers in the dust.

	Small-cap value stocks	Large-cap stocks
1999	-1.49 percent	20.91 percent
2000	22.83 percent	-7.79 percent
	(Small-cap value stocks shows returns for the Russell 2000 Value Index.)	(Large-cap stocks shows returns for the Russell 1000 Index.)

We can also see that small-cap value stocks substantially underperformed large-cap stocks in 1999. Unfortunately, there's really no way of consistently predicting which areas of the market will fare better than other areas. That's why diversification across many asset classes is important. If you diversify, when one asset class is performing poorly, another asset class may be performing well, and this combination could attenuate any drop in the value of your portfolio.

Finding a Fund

"Even for money managers, it is very difficult to time the market correctly. If a small-cap value fund manager held substantial amounts of cash in 1999, it's likely that the manager missed out on at least part of the small-cap value turnaround that occurred in 2000." — Cathy Smart, senior analyst at mPower Advisors, L.L.C.

If you participate in your company's retirement plan, your small-cap fund choices may be limited — indeed, your plan may not include any dedicated small-cap value funds. Instead, the plan sponsor may have opted to include a small-cap blend fund (one that invests in both value and growth) or may have opted for a small-cap growth option, as growth stocks substantially outperformed value stocks in 1998 and 1999.

But there are a few ways that you can add small-cap value funds to your retirement portfolio, even if they aren't in your employer-sponsored plan. Some plans offer a mutual fund brokerage window that allows you to pick from many funds on your own. If you don't have a brokerage window, you may want to consider opening an individual retirement arrangement (IRA), which generally allows you to choose from a wide universe of mutual funds.

Active vs. Passive Management

When choosing a small-cap value fund, you first should consider whether to invest in one that is actively or passively managed.

• An actively managed small-cap value fund has a portfolio manager who actively picks stocks. She chooses stocks that she thinks will help her fund outperform the benchmark.
• Only a few companies offer passively managed small-cap value funds (index funds). A passively managed small-cap value fund will be composed of the same stocks as a small-cap value benchmark, such as the S&P SmallCap 600/BARRA Value Index. The weight of those stocks will also match the weight of the stocks in the benchmark. If competently managed, a passively managed fund stays true to its style and is always invested in small-cap value stocks. Well-managed small-cap value index funds will have low expense ratios (total fund expenses divided by average total assets for the fund) of approximately 0.25 percent, and should have returns that are in line with the benchmark that the fund is trying to replicate.
• The merits of active and passive management are disputed, but there is evidence to suggest that managers of actively managed small-cap funds have a better chance at beating their benchmarks than their large-cap counterparts. That said, active management comes at a price, and the operating expenses of the average actively managed small-cap fund are substantially higher than those of the average passive fund.

Picking Active Funds — Five Tips

If you decide that an actively-managed fund is right for you, consider the following:

1. Look for a small-cap value fund that has met or exceeded the performance of its benchmark over the past 3-, 5-, and 10-year periods, not just the past year. You can request performance information from the fund company by phone, or you may be able to find it on the fund company's Web site.
2. Look for a fund with low expenses because expenses diminish returns. The average expense ratio for an actively managed small-cap value fund is approximately 1.55 percent.
3. Look for a fund that does not try to time the market by holding substantial amounts of cash. Even for money managers, it is very difficult to time the market correctly. If a small-cap value fund manager held substantial amounts of cash in 1999, it's likely that the fund missed out on at least part of the small-cap value turnaround that occurred in 2000. Call the fund company and ask it to provide you with historical quarterly cash balances for the fund.

   Related Reading Find the Right Benchmark to Judge Your Investment Success Wall Street 101: Introduction to Asset Allocation Mutual Funds - Generation X or Grande Dame

4. The fund should consistently invest primarily in small-cap value stocks. A fund company should be able to tell you if its management sticks to that asset class.
5. Keep in mind that if fund management recently changed, a fund that performed well in the past may not perform in a similar fashion going forward. Information regarding manager tenure can generally be found on the fund company's Web site and in a fund prospectus.

The bottom line: Diversification is key. If you didn't hold any small-cap value stocks in your portfolio last year, you missed out on some good returns. And since you never know what type of stocks will be in favor, remember that investing in a broad array of mutual funds that invest in different asset classes is the way to go. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Small-cap Value Stocks Buck the Bear Market

By Cathy Smart
Analyst, mPower

In This Story Small-cap Value Defined Small-caps — Value vs. Growth Small-cap Value vs. Large-cap Finding a Fund Active vs. Passive Management Picking a Fund — Five Tips

Your retirement portfolio has declined by 40 percent over the past year. In 1999, when the market was going wild, you parked your investments in large-cap and technology "growth" stocks. Who would have thought the boom would end?

Well, the boom did end. In 2000, the market went down almost 11 percent, as measured by the Wilshire 5000, an index that measures the performance of all U.S. stocks. And through the first quarter of this year, that index was down another 12.3 percent. Consequently, most people have seen the value of their retirement accounts drop substantially. But even in this down market, one asset class still managed to perform well and, as part of an investment portfolio, could have stemmed the bloodletting created by those growth holdings: small-cap value.

minute: read this article at a glance.

Technical Terms Capitalization Growth stock Price/earnings ratio Small-cap value stocks Style Value investing

Small-cap Value Defined

Small-cap companies have market capitalizations below $1.5 billion. (Market capitalization is the share price of a stock multiplied by the total number of shares outstanding at a given time.) These stocks can be divided into two groups: small-cap value and small-cap growth. What's the difference?

• A small-cap value stock is one that is undervalued when compared to its historical stock price, its industry peers, or the average small-cap stock. It also typically has a lower price-to-earnings ratio (P/E) than the average small-cap stock.
  • Example: IHOP Corp., which operates International House of Pancakes restaurants. At the end of 2000, IHOP's market capitalization was $434 million. Its P/E was 12.6 compared to the average small-cap stock's P/E of approximately 20.
  • IHOP's performance in 2000? Up 30 percent.
• Small-cap growth stocks are those that are expected to have above-average earnings growth. Small-cap growth fund managers may be willing to pay a high price for this growth, so the P/E ratios of small-cap growth stocks tend to be higher than the P/E of the average small-cap stock.
  • Example: Radiant Systems, a company that manufactures computer systems. At the end of 2000, Radiant's market capitalization was $568 million. Its P/E was 47.7 compared to the average small-cap stock's P/E of approximately 20.
  • Radiant's performance in 2000? Down 23.5 percent.

Small-caps — Value vs. Growth

Knowing about these two asset classes is important precisely because they can potentially perform differently from each other. In fact, the recent divergence between the performance of small-cap value and growth stocks is remarkable, as evidenced by the numbers below. For the year ending Dec. 31, 2000, small-cap value stocks drastically outperformed their small-cap growth counterparts.

	Small-cap value stocks	Small-cap growth stocks
1999	-1.49 percent	43.09 percent
2000	22.83 percent	-22.43 percent
	(Small-cap value stocks shows returns for the Russell 2000 Value Index.)	(Small-cap growth stocks shows returns for the Russell 2000 Growth Index.)

These numbers show us that small-cap growth stocks dominated small-cap value stocks in 1999, but in 2000, small-cap value stocks started to recover. For the year ending Dec. 31, 2000, small-cap value stocks crushed their small-cap growth counterparts.

"If you didn't hold any small-cap growth stocks in 1999, you missed out on some nice returns. And if you didn't hold any small-cap value stocks over the past year, your portfolio may have dropped more than it had to." — Cathy Smart, senior analyst at mPower Advisors, L.L.C.

The numbers also demonstrate that markets can change drastically over a short period of time. If you didn't hold any small-cap growth stocks in 1999, you missed out on some nice returns. And if you didn't hold any small-cap value stocks over the past year, your portfolio may have dropped more than it had to.

Small-cap Value vs. Large-cap

You might recall that in 1999, large-cap growth stocks had a great year. Intel, for example, was up 39.1 percent in 1999. But the markets turned around in 2000, causing many large-cap growth stocks to decline (Intel was down 26.9 percent in 2000).

And what about large-cap value stocks? They certainly fared better than their large-cap growth counterparts during this slumping market, but they didn't even come close to performing as well as small-cap value. When looking at the performance of large-cap stocks as one group (combining both growth and value stocks), we can see that small-cap value left its large-cap peers in the dust.

	Small-cap value stocks	Large-cap stocks
1999	-1.49 percent	20.91 percent
2000	22.83 percent	-7.79 percent
	(Small-cap value stocks shows returns for the Russell 2000 Value Index.)	(Large-cap stocks shows returns for the Russell 1000 Index.)

We can also see that small-cap value stocks substantially underperformed large-cap stocks in 1999. Unfortunately, there's really no way of consistently predicting which areas of the market will fare better than other areas. That's why diversification across many asset classes is important. If you diversify, when one asset class is performing poorly, another asset class may be performing well, and this combination could attenuate any drop in the value of your portfolio.

Finding a Fund

"Even for money managers, it is very difficult to time the market correctly. If a small-cap value fund manager held substantial amounts of cash in 1999, it's likely that the manager missed out on at least part of the small-cap value turnaround that occurred in 2000." — Cathy Smart, senior analyst at mPower Advisors, L.L.C.

If you participate in your company's retirement plan, your small-cap fund choices may be limited — indeed, your plan may not include any dedicated small-cap value funds. Instead, the plan sponsor may have opted to include a small-cap blend fund (one that invests in both value and growth) or may have opted for a small-cap growth option, as growth stocks substantially outperformed value stocks in 1998 and 1999.

But there are a few ways that you can add small-cap value funds to your retirement portfolio, even if they aren't in your employer-sponsored plan. Some plans offer a mutual fund brokerage window that allows you to pick from many funds on your own. If you don't have a brokerage window, you may want to consider opening an individual retirement arrangement (IRA), which generally allows you to choose from a wide universe of mutual funds.

Active vs. Passive Management

When choosing a small-cap value fund, you first should consider whether to invest in one that is actively or passively managed.

• An actively managed small-cap value fund has a portfolio manager who actively picks stocks. She chooses stocks that she thinks will help her fund outperform the benchmark.
• Only a few companies offer passively managed small-cap value funds (index funds). A passively managed small-cap value fund will be composed of the same stocks as a small-cap value benchmark, such as the S&P SmallCap 600/BARRA Value Index. The weight of those stocks will also match the weight of the stocks in the benchmark. If competently managed, a passively managed fund stays true to its style and is always invested in small-cap value stocks. Well-managed small-cap value index funds will have low expense ratios (total fund expenses divided by average total assets for the fund) of approximately 0.25 percent, and should have returns that are in line with the benchmark that the fund is trying to replicate.
• The merits of active and passive management are disputed, but there is evidence to suggest that managers of actively managed small-cap funds have a better chance at beating their benchmarks than their large-cap counterparts. That said, active management comes at a price, and the operating expenses of the average actively managed small-cap fund are substantially higher than those of the average passive fund.

Picking Active Funds — Five Tips

If you decide that an actively-managed fund is right for you, consider the following:

1. Look for a small-cap value fund that has met or exceeded the performance of its benchmark over the past 3-, 5-, and 10-year periods, not just the past year. You can request performance information from the fund company by phone, or you may be able to find it on the fund company's Web site.
2. Look for a fund with low expenses because expenses diminish returns. The average expense ratio for an actively managed small-cap value fund is approximately 1.55 percent.
3. Look for a fund that does not try to time the market by holding substantial amounts of cash. Even for money managers, it is very difficult to time the market correctly. If a small-cap value fund manager held substantial amounts of cash in 1999, it's likely that the fund missed out on at least part of the small-cap value turnaround that occurred in 2000. Call the fund company and ask it to provide you with historical quarterly cash balances for the fund.

   Related Reading Find the Right Benchmark to Judge Your Investment Success Wall Street 101: Introduction to Asset Allocation Mutual Funds - Generation X or Grande Dame

4. The fund should consistently invest primarily in small-cap value stocks. A fund company should be able to tell you if its management sticks to that asset class.
5. Keep in mind that if fund management recently changed, a fund that performed well in the past may not perform in a similar fashion going forward. Information regarding manager tenure can generally be found on the fund company's Web site and in a fund prospectus.

The bottom line: Diversification is key. If you didn't hold any small-cap value stocks in your portfolio last year, you missed out on some good returns. And since you never know what type of stocks will be in favor, remember that investing in a broad array of mutual funds that invest in different asset classes is the way to go. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.