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Russell 2000 in year 2000
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February 1, 2000: 8:11 a.m. ET
So far this year, small caps are the best bets -- but don't get duped
By Staff Writer Alex Frew McMillan
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NEW YORK (CNNfn) - Amid the ballyhoo about the Nasdaq ripping through performance records last year, you may have missed one trend that hasn't happened for years -- small-cap stocks, as measured by the Russell 2000 index, outperformed their larger brethren in the S&P 500 last year.
That was thanks to a year-end burst that started in October, and the pattern has spilled over into this year. Up 3.7 percent year to date, including dividends, the Russell 2000 is rather fittingly the best-performing major index of 2000, or at least through Jan. 24 anyway.
The choppy markets have made the Russell 2000 look particularly good. The week ended Jan. 21 saw it beat the S&P 500 by 6.8 percentage points, its largest margin of outperformance since the Russell's inception in 1979.
The Russell 2000 even beat out the high-flying Nasdaq composite for the week, and its gains were steady, at least a percentage point a day. Other small-cap indexes such as the S&P 600 Small Cap also did well.
The performance is a welcome respite after an extremely difficult second half of the '90s for small-cap stocks. The market has yawned over small companies and fawned over techs and large-cap growth stocks.
But doctrine holds that over time small-cap and large-cap stocks post similar returns. The idea that small-cap stocks are rebounding catches on periodically, and gathered some momentum last summer. Now the numbers are backing the theory up.
So are small-cap companies back? And what should you do about their rebirth?
Investors ditch large caps, looking for deals
"I absolutely think it will continue," said Howard Penney, an analyst who breaks down the Russell 2000's weekly performance for Morgan Stanley Dean Witter. "It can't last forever but generally the fundamentals are very strong."
The boom in the Russell 2000 is partly a product of the group having been beaten down for a number of years, Penney admitted. But that doesn't make the trend any less real, and it doesn't stop opportunistic investors from capitalizing on it.
"It's more than an interesting statistic," he said. For a long time, investors figured the only way you could make money was with large caps. But some investors have started to wonder if they haven't run the large-cap ride as far as they can, particularly when stocks like Lucent Technologies (LU) implode, as it did at the start of this year.
With a fall burst, the Russell edged the S&P 500 in '99. It's also the top-performing index this year.
So bargain hunting is creeping back into fashion. "A lot of people are thinking about moving down the valuation spectrum, and you can find some reasonably priced, growing small-cap names," Penney said.
Cash flows into small-cap stock mutual funds are strong. The brave will pick specific stocks --however, the small-cap universe is so much larger and some of the stocks are so much more illiquid that you have to be certain that you know what you're doing.
Don't let statistics lie to you
But, don't be duped by the Russell 2000's rebound, investment experts warn. The wealth is not spreading very widely at all. Technology and biotechnology stocks have powered its good performance.
"It's a misnomer to say that small caps have come back," said Ted Kellner, who manages the FMI Focus Fund. It concentrates on a small number of small- and mid-cap stocks and was up 7.4 percent through Jan. 24, according to fund tracker Morningstar.
"This market, I've been the business 32 years, and I've never seen anything like it, it's so bifurcated. It's unbelievable," Kellner said.
The same trends that have driven large-cap stocks just seem to have spilled over into the small-cap world, as large caps got so expensive. Last year, the Russell 2000 growth index grew an extremely impressive 43.1 percent. But the Russell 2000 value index lost 1.5 percent.
The same sectors -- technology, telecommunications and the Internet -- that already earned high grades in the large-cap market have altered the curve on the Russell 2000, too. Kellner figures that 246 companies in the Russell gained more than 100 percent in stock price last year.
He thinks that has seriously skewed the index. The Frank Russell Co. rebalances its indexes once a year. When it came up with a new Russell 2000 last May, the largest company had a market capitalization of $1.5 billion. Now around 140 companies have more than $1.5 billion in market capitalization, Kellner pointed out.
Those companies have produced the numbers. "These aren't small-cap companies," he said. "They're companies that have gone from nowhere to huge market caps."
So where to go from here?
Kellner's fund is 30 percent technology, but he steers clear of most of the stocks that are driving the market. He thinks they're too expensive. There are good small-cap values, he said, because many small companies make good buyout prospects for larger companies fat with stock.
Kellner also predicts a resurgence in leveraged buyouts at small-cap companies that don't share in the market gains.
He is easing his exposure to the telecommunications sector, which he has ridden up but thinks is expensive. Cable companies and Internet infrastructure companies are also at "extremely high valuations," he said. He is bulking up on financial and health-care stocks instead.
Chris Callies, chief equity strategist for CS First Boston, said she thinks the money is filtering into a couple of small-cap sectors only after exhausting the same large-cap sectors.
"Investors are trying to chase the momentum growth story to its last refuge," she said. "They're going to exploit every niche in the growth theme before they start looking for alternatives."
Callies said she expects a burst of money moving into small caps very quickly. "This could be a very profitable short-term phenomenon," she said, but added that the rally is very selective.
The renewed interest means a higher "flavor of the month" quotient with small-cap stocks. Fund manager Kevin O'Boyle, who runs the Meridian Value Fund, said the market has been very selective and a little cavalier.
"In the last year, all of a sudden a company gets perceived differently than it had been, and someone decides that the market cap should be taken way up," O'Boyle said.
That means stock picking gets even more difficult. "Sometimes you get punished by buying too early, and if you get in too late you're probably paying up for these stocks," he said.
O'Boyle said he forsakes technology stocks for companies such as Ucar International (UCR) and Haemonetics (HAE), which have been through a reorganization and are poised to renew former earnings growth. Picking small caps "is very time intensive, and very labor intensive," he said.
Switch your sectors not the size of stocks
Callies said she doesn't expect small-cap stocks to outperform this year, though she said they may again match the S&P 500's performance. So don't chuck all your large-cap holdings for small-cap tech and biotech stocks, unless you're trying to ride a quick trend and can get out.
Callies said she thinks Kellner is wise to expand his horizons with other investment sectors instead. Consumer-cyclical stocks benefit from sustained economic growth and have adjusted their businesses so they carry very low inventories. But the market doesn't appreciate their stability and structural changes, she said.
"Most people have loaded up on tech and don't have anything else," Callies said. "We're saying there are a lot of other areas that are going to benefit from sustained economic growth," she said. 
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