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Wall Street, California: Insight for Investors

Small--and Unloved--Stocks Have Big Potential

March 31, 1998|WALTER HAMILTON | TIMES STAFF WRITER

How can you tell small-cap stocks from large-cap stocks?

Small stocks are the ones with the better earnings.

Not that many investors have noticed, but profits of small companies as a group have consistently risen faster than those of large companies for the last three quarters--even though small companies' stocks have lagged large stocks for much of that period.

And the profit gap is expected to widen noticeably when first-quarter data are reported over the next few weeks.

Analysts estimate that profits for companies in the Standard & Poor's 500-stock index will rise only 0.8% in the first quarter versus a year earlier, according to earnings tracker First Call Corp. in Boston. That's the lowest quarterly growth rate in more than six years.

On the flip side, earnings of companies in the Russell 2,000 index of smaller stocks are forecast to rise 10.7% in the quarter. Most important, they're expected to hold that lead for some time.

"I don't know if it's going to widen much further from here, but it's certainly not going to contract," said Chuck Hill, First Call's research director.

The Asia crisis gets most, though not all, of the blame for the sudden earnings woes of larger stocks, which of course include many multinationals. Weakness in the region has prompted a number of companies to warn that profits will fall shy of forecasts.

Other large companies, however, have blamed industry-specific trends for their expected profits shortfalls. Intel and Compaq fall into the latter category.

By contrast, small-cap companies' earnings should hold up because the companies are far less exposed to Asia and much more dependent on the U.S. economy, which has remained vibrant.

"Who's more likely to stub their toes" in Asia? asked Satya Pradhuman, small-cap research director at Merrill Lynch. "We think it's the large companies."

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There's other good news for small-cap stocks. For the last three quarters, a greater percentage of small companies than large ones have "significantly" beaten analysts' earnings estimates, Pradhuman said. Companies with such positive surprises are often rewarded with higher stock prices.

In the fourth quarter of 1997, 32% of small companies had significant positive earnings surprises compared with 20% for large companies, Pradhuman said.

The earnings worries of larger stocks, though, haven't slowed the progress of blue-chip stock indexes such as the S&P 500 and the Dow Jones industrial average. In the quarter through Monday, the S&P was up 12.7% while the Dow tacked on better than 11%.

By contrast, the Russell 2,000 index of smaller stocks has lagged, with a 9% year-to-date gain.

Last year the S&P index jumped 31% while the Russell rose 20.5%.

For the moment, at least, Wall Street thinks large-cap companies' profits will rebound in the second half of 1998. For the year, S&P profits are projected to advance 9.8%, according to consensus Wall Street estimates.

So what? ask small stocks' proponents. The Russell 2,000 companies' earnings are expected to balloon 24.5% for the full year.

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For investors who believe that small- and mid-sized companies' earnings will be as good as expected--and that their stock prices may finally begin to reflect that--this is a good time to be shopping for potential winners, analysts say.

The chart accompanying this story, compiled with the help of First Call, gives a random sampling of small- and mid-sized companies in the Russell 2,000 whose earnings are expected to grow strongly in the first quarter.

It's important to keep in mind that a huge projected jump in quarterly earnings is not in itself a sufficient reason to buy a stock.

A high quarterly growth figure could mean that year-ago earnings were abnormally low. In such a case, a company's absolute profit could be weak even though the percentage gain is high.

Similarly, the earnings-per-share gain of a tiny company with relatively few shares outstanding could be misleading.

If a company earns 2 cents a share this quarter versus 1 cent in the year-ago period, its gain is 100%. But earning only a few cents per share is a hallmark of small and unproven companies with highly volatile profits.

To weed out such names from the accompanying chart, The Times asked First Call to limit the list to companies meeting certain criteria:

* Earnings must be projected by the analysts following the company to grow solidly in the next five years.

* The company must have been profitable in the past five years (or for as long as it has been publicly traded).

* The projected first-quarter increase in earnings, in absolute dollars, must be at least $3 million.

* At least three analysts must follow the company.

First Call generated more than 100 names with its screens, from which The Times selected 30 to show as a representative sampling.

Here are profiles of five of the companies:

Airborne Freight

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There's more to overnight delivery than FDX Corp. and United Parcel Service.

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