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Analysis
Small-cap manager cautions investors that valuations are pretty high

By Chet Currier
Bloomberg News Service

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Whenever a skilled tradesman points out flaws in his own wares, it's time to pay attention.

Candor of that kind is something you don't see every day.

So any investor caught up in the boom in small-company stocks might listen with both ears to what the manager of a prominent small-stock fund says.

"Small-caps have outperformed large-caps now for almost five years, and such cycles rarely last for more than six years," says Jack Laporte, in his 17th year at the helm of the $5.2 billion T. Rowe Price New Horizons Fund.

"We are clearly in the latter stages of this cycle," Laporte writes in the fund's annual report.

"Small-cap valuations are no longer at their usual discount to large-caps," he says.

The aggregate price-earnings ratio of the 200-plus stocks that New Horizons holds closed out 2003 at 28.1 to 1. That's "the highest level in decades with the brief exception of the 1999-2000 bubble period," Laporte writes.

Laporte says he has strong fundamental reasons for remaining bullish on small stocks, though, "With the economy and market upturns still in their early stages, some further near-term outperformance by small-caps seems likely," he says. "We expect our fund holdings to deliver earnings growth in excess of 20 percent over the next couple of years and believe that valuations are justified by this robust growth."

Even on investor sentiment in general, though, Laporte acknowledges some misgivings. "The outlook for the economy and the stock market in 2004 is quite positive," he says. "Perhaps the biggest concern is that this upbeat outlook is shared by almost all investors and market prognosticators. The consensus view is rarely right for an extended period."

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