Small-cap stocks finally seem to be having their Wile E. Coyote moment. Don’t tumble to the bottom of the cliff with them. By Steven Goldberg, Contributing Columnist August 24, 2010 Since the stock market bottomed on March 9, 2009, I’ve watched in amazement as shares of small companies have blown away shares of their larger brethren. From the trough of the 2007–09 bear market through August 20, the small-company Russell 2000 index returned a cumulative 81.5%, while Standard & Poor’s 500-stock index, which is dominated by large companies, gained 63.3%. In the early months of the rally, analysts attributed the surge in small caps to them simply rebounding more dramatically after having fallen harder during the bear market. It sounded sensible enough, but the fact is that the difference in performance between the Russell 2000 and the S&P 500 during the carnage was fairly minor: The S&P 500 plunged 55.3% during the bear market; the Russell 2000, 58.5%. Another plausible argument explaining the poor performance of large-cap stocks over the past year-plus is that investors have become wary of them after getting burned twice in the past decade. The primary culprits during the 2008 meltdown were stocks of large financial companies. During the 2000–02 bear market, the leading troublemakers were large-company growth stocks, particularly in the technology sector. Investors may still be shunning those sectors because of recent painful experiences. Certainly, there’s no rational accounting for loading up on small caps amid a remarkably feeble recovery following the worst recession since the Great Depression. (Not everyone agrees: See James K. Glassman’s piece lauding small caps.) Advertisement The Leuthold Group, a Minneapolis-based investment-research firm, says that small caps, in aggregate, boast higher price-earnings ratios relative to large caps than they have at any time since the firm began tracking the ratios in 1982. On average, Leuthold says, small caps are trading at 17.1 times estimated 2010 earnings. “Small caps are still selling at a fat valuation premium of 18% relative to large caps,” Leuthold reports. Typically, small caps trade at lower price-earnings ratios than large caps. Megacaps, the nation’s 50 largest stocks, are trading at a mere 12.9 times estimated earnings. In other words, small caps are expensive, large caps are cheap and megacaps are cheapest. It can take a long time, but those kinds of anomalies almost invariably end. Reversion to the mean is a powerful force in investing. Ignore it at your peril. The financial news is filled with articles about the reluctance of banks to lend money to small businesses. Meanwhile, large companies in need of money have been able to raise oceans of cash at record-low interest rates by issuing bonds. Many other large companies are awash in the green stuff and have no need to borrow. Small companies, by definition, are riskier than large ones. They tend to rely on one or two product lines and have fewer lenders, customers and suppliers than large companies. They’re also much less well equipped than the behemoths to take advantage of the main opportunity in today’s global economy: the growth in emerging markets. Advertisement The final straw for small caps Momentum often counts for a lot. No matter how irrational, sometimes it pays to wait until the tide actually turns before changing your investments. The old Wile E. Coyote cartoons used to show poor Wile run off the edge of a cliff but stay aloft, wheeling his legs under him, until he happened to look down and see his predicament. Only then did he fall to the ground. Well, small caps have finally looked down. Over the past 13 weeks through August 19, the Morningstar small-company index lost 7.1% while its large-cap index shed just 3.1%. What should you sell? I used Alexander Steele Mutual Fund Expert to identify small-cap funds with initial minimum investments of $10,000 or less and $1 billion or more in assets that lost more than 40% in 2008 (losses in this one year don’t coincide precisely with performance during the bear market, but they’re close enough to make my point). Advertisement The results: Oppenheimer Small & Mid Cap Value A (symbol QVSCX, –49.9%), Ariel (ARGFX, –48.3%), Fidelity Small Cap Independence (FDSCX, –47.0%), Royce Opportunity (RYPNX, –45.7%), Longleaf Partners Small-Cap (LLSCX, –43.9%), Fidelity Small Cap Stock (FSLCX, –42.9%), Vanguard Explorer (VEXPX, –40.4%), Baron Small Cap (BSCFX, –40.2%) and Keeley Small Cap Value A (KSCVX, –40.2%). These aren’t bad funds. Indeed, Baron Small Cap is on the Kiplinger 25, Kiplinger’s Personal Finance’s list of its favorite no-load funds. But they make no sense today. What percentage of your stocks should be in small caps? Keep in mind that small caps represent just 8% of the total value of the U.S. stock market. Don’t invest much more than that, and stick to conservative funds, such as Royce Special Equity (RYSEX) and T. Rowe Price Small-Cap Value (PRSVX), which lost only 19.6% and 28.6%, respectively, in 2008. Or avoid small caps altogether. Over the long haul, the statistics are clear: Small-company stocks beat large-company stocks. But there’s a season for every kind of investment. And this is not the time to own small companies. Steven T. Goldberg (bio) is an investment adviser.