With stocks, time to think small

Analysis |

While small-company stocks typically lead the way out of bear markets, a more important reason to invest in the category is long-term performance. Small-capitalization stocks — those with a market value of $3 billion or less — usually rally before large caps at the end of bear markets, and before the economy recovers, says Citi Investment Research analyst Lori E. Calvasina.

While she expects the small-cap Russell 2000 index, currently near 470, to rise to 550 by the end of 2009, she says it might first sink near its Nov. 20 low of 385.31 as weak fourth-quarter earnings trickle in. "While our analysis is not calling for a clear shift into smaller-cap stocks just yet, we continue to believe that the stage is being set for such an inflection point in 2009," she writes in a report.

Merrill Lynch strategist Steven G. DeSanctis says investors should always keep a small portion of their portfolios in small caps, as they tend to outperform large-cap stocks over time. "Although we spend an inordinate amount of time attempting to figure out if we are in the midst of a small-cap outperformance cycle or not, investors should focus more on the longer-term picture when making investment decisions," he says.

Large caps are considered safer during troubled economic times as they have more diverse revenue than small caps.

Some fund managers see good opportunities now, especially after the market's sharp drop in recent months. "Whenever you get into a market like this that hits every type of stock, small caps get hit the hardest," says Craig Hodges, portfolio manager for the multicap Hodges fund (HDPMX). He's looking at energy and infrastructure names such as KBR (KBR), Terex (TEX) and Atwood Oceanics (ATW).

Larry Mano, portfolio manager of the Schwab Core Equity Fund (SWANX), sees opportunities across all small-cap sectors, based on low valuations and relatively higher earnings growth expectations.