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MARKET BEAT / TOM PETRUNO

Small-Company Stocks Going for Three in a Row

August 18, 1993|TOM PETRUNO

Small-company stocks, the market's stars in 1991 and 1992, are trying for a hat trick.

With a summer rally, major indexes of smaller stocks have again overtaken big-company stock indexes. And the momentum of small stocks is building as the market heads into autumn--a traditionally strong time for these issues, as investors return from vacation to focus on companies' prospects in the approaching new year:

* Since July 15, the NASDAQ composite index of 4,000 mostly smaller stocks has risen 3.1%, compared to a mere 0.9% rise in the blue-chip Standard & Poor's 500 index.

Tuesday, the NASDAQ index hit another record high, rising 4.12 points to 731.01. Meanwhile, the S&P index, up 0.75 point to 453.13 on Tuesday, remains below its peak of 456.33 reached in March.

* A less visible but truer measure of small-stock performance--the Russell 2000 index--also hit a new high Tuesday, up 1.07 points to 241.25. And year-to-date, the Russell index is up 9.2%, better than the NASDAQ index's 8.0% rise and more than twice the 4.0% gain in the S&P.

The Russell index is a more accurate indicator of small stocks' trend because it contains only small stocks. The NASDAQ index, in contrast, is skewed by the presence of a handful of huge technology stocks (Intel Corp. and Microsoft, among others) that dwarf most NASDAQ stocks.

Thus, the Russell's rally shows that the NASDAQ rally isn't just big tech issues: There is broad buying in truly small stocks as well.

*

That is in fact what Dean Witter Reynolds, one of the nation's largest brokerages, is seeing. Philip Roth, technical market analyst at Dean Witter in New York, says his firm has witnessed "peak buying" activity by individual investors in NASDAQ stocks in recent weeks. At the same time, their purchases of New York Stock Exchange stocks have slowed sharply, Roth says.

He notes that while the trend is encouraging for anyone betting on a small-stock surge, it also suggests a speculative tone in the market--which may mean trouble in the long term.

Some small-stock pros, however, say the NASDAQ market is again outpacing blue-chips for good reason: Generally, smaller firms continue to post faster earnings growth than larger companies.

Douglas Foreman, manager of the $370-million Putnam OTC Emerging Growth stock mutual fund in Boston, says that even with the steady rise in smaller stocks since 1990, "I can still find plenty of opportunities in the market." That's because many smaller firms have managed to wring sensational earnings from an anemic economy, he says.

The average stock in his portfolio now sells for 20 times estimated 1994 earnings per share, Foreman says. While that may strike some investors as expensive (it's certainly in the upper range for stock price-to-earnings ratios, historically), Foreman says the average estimated annual earnings growth for his companies is 27%, looking out five years. His fund owns such NASDAQ names as cable TV programmer Liberty Media, soft drink phenom Snapple Beverage and computer networker Wellfleet Communications.

Any time a stock's price-to-earnings ratio is below its growth rate, simple math suggests a bargain, Foreman notes. "I don't see how I can not make money," he says. So far, he's been right: His fund, up 12.7% last year, is up about 14% this year.

What could go wrong, of course, is that Foreman's earnings estimates turn out to be too high. But that would require a dramatic downturn in the economy, he says, and he doesn't see it.

Foreman's results aside, however, the average investor in small-stock mutual funds isn't keeping up with the Russell index. Through last Thursday, fund tracker Lipper Analytical calculated that the typical small-stock fund is up 7.1% in 1993. That isn't much above the 6% gain in the average blue-chip (growth and income) fund.

The blue-chip funds have been helped in part by those stocks' high dividends, which make up for slower share-price appreciation. But the sub-par small-stock fund average gain also suggests that it's getting harder to pick the right small stocks. Some fund managers clearly are struggling.

The good news is that the longer this rally runs, the more investor interest in small stocks is likely to swell. That could bring a tide of new money into the market this fall, boosting the odds of a third year of small stocks beating blue-chips.

Small Stock Rally: Year 3 in Progress

Small-company stocks, as measured by the Russell 2000, NASDAQ composite and American Stock Exchange indexes, are once again outperforming the bigger stocks in the Standard & Poor's 500 and New York Stock Exchange composite indexes.

Percentage change: Index 1991 1992 1993 Amex market value +28.2% +1.1% +10.9% Russell 2000 +43.4% +16.5% +9.2% NASDAQ composite +56.8% +15.5% +8.0% NYSE composite +27.1% +4.7% +4.6% S&P 500 +26.3% +4.5% +4.0%

Source: Los Angeles Times

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