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Few Weak Points Seen in Strength of Smaller, 'Value' Stocks

Wall Street: Funds combining the shares rose an average of 8.7% in the first quarter. Factors may keep them in favor.


Smaller stocks and "value"-oriented shares have been Wall Street's leaders this year, building on what is now a 2-year-old trend.

But the continuing gains in those market sectors also pose key questions for investors: Is there still value in value, and can smaller stocks keep generating bigger returns than blue chips?

Many mutual fund managers who have benefited from what has been dubbed a stealth bull market in smaller shares and value issues said that despite the strength in those sectors, they aren't having trouble finding good ideas.

That may sound similar to what technology-stock fund managers said at the tech sector's peak in March 2000, but small-stock fund managers and value-fund managers said there's no comparison.

"My feeling is we're early in a cycle. We could be in the second year of a five-year cycle for the market," said Buzz Zaino, manager of Royce Opportunity, a small-stock value fund that climbed 10.1% in the first quarter.

Smaller stocks and value-oriented issues took a back seat to big-company stocks and "growth"-company shares, especially technology issues, in the late 1990s. But since the broad market peaked in spring 2000, smaller stocks and value issues have ruled Wall Street.

Small-stock value funds have risen an average of 20.2% a year over the last three years, according to fund tracker Morningstar Inc. The sector leads all others tracked by Morningstar.

Meanwhile, the large-cap growth stock funds that still have a far bigger chunk of investor assets have lost an average of 5.8% a year over the last three years.

Optimism about an economic recovery lifted growth stocks in the fourth quarter. But value stocks took back the lead in the first quarter.

Small-cap value funds gained an average of 8.7% in the first quarter, while large-cap growth funds lost 2.7% on average, according to Morningstar.

Don Cassidy, senior research analyst at fund-tracker Lipper Inc. in Denver, called the rally from the stock market's Sept. 21 low--which saw the tech-dominated Nasdaq composite index surge 45% in 3 1/2 months--"more of a snap-back reaction than a meaningful trend."

Cassidy said the renewed slide in tech stocks in the first quarter showed that many investors remain nervous about still-high price-to-earnings valuations on classic growth shares.

That sentiment could continue to work in favor of value stocks, which typically sell for relatively low valuations relative to earnings, assets and other measures. Value issues also often sport high dividend yields--a cushion in times of market trouble.

The prospect of rising interest rates this year, as the economy recovers, also may be turning more investors toward small-company stocks, some analysts say.

Zaino said he is reminded of the period from the mid-1970s through the early 1980s, when small stocks consistently outperformed blue chips as interest rates rose.

Higher interest rates typically put more pressure on larger stocks, Zaino said, because they trade in "a more efficient market" in which their price-to-earnings ratios often contract in response to rising rates, whereas smaller companies "just trade on their earnings," he said.

Also, investors worried about getting stuck with another Enron Corp. are shying away from conglomerates and companies whose business plans and financial statements are confusing, some said.

"Smaller is simpler is better," said Tom Perkins, manager of the Berger Mid-Cap Value fund, which gained 5.5% in the first quarter.

Small- and mid-cap value fund managers said they still are finding plenty of undervalued stocks to buy, although they are looking in unusual places--including in the tech and telecom sectors, once the domain of growth managers.

David Wallack, whose T. Rowe Price Mid-Cap Value fund rose 10.1% in the first quarter, said he is finding "good risk/reward characteristics" in tech and telecom.

"It's not an explicit bet that the sector is going to be in great shape in the next three, six, 12 months, but looking out two years I see better times for some of these companies that have good balance sheets," Wallack said.

Two stocks he bought in the first quarter are ADC Telecommunications Inc. (ticker symbol: ADCT), which sells equipment to established phone carriers, and Molex Inc. (MOLX), which sells switches and other electronics gear. Both firms have experienced managers who have been through economic cycles before, he said.

"Neither of these companies worries too much about quarterly earnings. They focus on the long term and don't gut the business to make Wall Street happy."

Zaino said he is finding tech companies "where, if you rip the company name off the quarterly financial report, you could make a Graham-and-Dodd guy salivate," referring to two value investing legends.

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