By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) -- The biggest surprise of the stock market's rally since October 2002 has been the relentless strength of small-company shares. The textbook does say small-caps lead a recovery, but at some point the little guys are supposed to step aside for the big boys.
Many experts thought they'd witness this leadership change last year. But so far, no dice. The small-cap Russell 2000 Index benchmark /zigman2/quotes/210598147/delayed RUT -0.36% rose 14% in the first three months of this year, while the large-cap Standard & Poor's 500 Index /zigman2/quotes/210599714/realtime SPX -0.30% rose 4.1%. On Tuesday, the small-stock laden Nasdaq hit a five-year high.
"They just keep going," said Jeff Tjornehoj, a senior research analyst at fund tracker Lipper Inc., of the small-cap surge." There continues to be enough good news about the economy to keep people's hopes up. At some point, investors ... start to think of the safety of large caps to counter the coming downturn. Evidently, no one thinks that's in the offing."
The gulf between large and small also extends to mutual funds. Small-cap funds averaged a 12% gain in the first quarter, while large-caps rose 3.8%, according to Lipper. For three years, small-stock funds' 27.8% annualized average return tops large-cap's 16.2% average advance. See complete mutual funds quarterly coverage.
Given such tremendous results, would buying small stocks now be ill-timed?
"I think we're in the 11th hour" for small-caps, said John Goode, co-manager with Peter Hable of the Smith Barney Fundamental Value Fund /zigman2/quotes/205141789/realtime SHFVX +1.65% .
Only about 5% of the $4.5 billion fund is committed to small-cap shares, Goode said, compared with 20% typically. Large caps offer better value, he said, and if the U.S. market becomes more volatile, as Goode and others expect, investors likely will flock to the relative safety of large-company shares.
In fact, stock-fund investors already have most of their money in large-caps and relatively little in small-caps. The combined assets of the U.S. small-cap growth, core and value funds that Lipper covers totaled about $340 billion at the end of March. The large-cap value fund category alone registers $392 billion. Add sibling core and growth funds, and the total assets in U.S. large-cap funds climbs to more than $1.1 trillion, according to Lipper.
"Most clients that come to us have little or no small-cap exposure," said Mark Balasa, a financial adviser with Balasa, Dinverno & Foltz in Itasca, Ill. "They say 'it's risky, or 'I lost money.' Then people see this outperformance and think 'should I get on,' and they keep waiting."
Balasa's advice is straightforward: Keep 15% of your stock portfolio in small caps. If you have less, he added, buy small caps. And if highly appreciated small-cap stocks or funds make up more than 15% of the portfolio, take some money off the table.
"Small caps are modestly overvalued, but not dramatically overvalued, relative to large caps," Balasa said. "But we would have thought that last year."
Openings in a small door
Still, small-cap funds have absorbed huge amounts of money in a short time, which grates against the sector's nature. Small caps offer niche opportunities for nimble investors. But a small-cap fund bloated with cash can't always seize those opportunities or buy enough of an issue to make a meaningful difference in performance.
Accordingly, popular, actively managed small-stock funds including Vanguard Explorer Fund /zigman2/quotes/205808530/realtime VEXPX +2.29% , Century Small Cap Select Fund /zigman2/quotes/204934713/realtime CSMVX +1.94% and Third Avenue Small Cap Fund /zigman2/quotes/209823731/realtime TASCX +2.21% , among others, have shut out new shareholders in recent months.
But there are lesser-known small-cap funds that boast good performance, experienced management and low asset bases.
"That's a very tough combo to find these days," said Russel Kinnel, director of fund research at investment researcher Morningstar Inc.
One of the only open small-cap funds on Morningstar's recommended list is Champlain Small Company Fund /zigman2/quotes/200762617/realtime CIPSX +1.89% , with about $33 million in assets. Kinnel notes that manager Scott Brayman and his team run the no-load portfolio with a disciplined, value-conscious approach.
Finding small-cap funds that take new shareholders also focuses Thurman Smith, editor of Equity Fund Outlook, a monthly newsletter.
One of Smith's favorites is Paradigm Value Fund /zigman2/quotes/207227431/realtime PVFAX +2.21% , a $37 million portfolio that manager John Walthausen launched in December 2002. The fund's three-year annualized 43% return lands it at the head of its small-value class, according to Morningstar. Smith said he likes the fund's fundamental approach to stock selection, gravitating to innovative companies with new products and notable, share-moving catalysts.
Another tiny small-cap value fund on Smith's radar is Perritt Emerging Opportunities Fund /zigman2/quotes/205310108/realtime PREOX +2.10% , which invests in companies with market capitalizations of less than $250 million. "It's a chance to get the real small stuff," Smith said, praising the fund for delivering above-average returns with below-market risk.
Michael Corbett, who runs the $82 million fund with Gerald Perritt, said that spreading assets across 105 companies mitigates risk. "We're big sticklers for maintaining broad diversification," Corbett said.
And though small-cap stocks aren't cheap, Corbett added, the group is reasonably priced based on his estimates of expected earnings growth, particularly the energy-services sector. "It's not like we're at two or three times growth," he said. "We're still at 1 to 1.2, which is higher than it's been but not that bad."
Two other offerings on Smith's short list are Cambiar Conquistador Fund /zigman2/quotes/208899958/realtime CAMSX +1.97% and Constellation Small Cap Value Opportunities Fund .
The Cambiar portfolio blends growth and value investing styles, and has gained 33.2% in the 12 months through Monday. Smith said that although the fund is less than two years old, he likes the management team's longer record at large-cap sibling Cambiar Opportunity Fund /zigman2/quotes/209711246/realtime CAMOX +1.51% . "You can't argue with the progress," Smith said.
A like-minded view guides Smith to the Constellation offering, a three-year old fund that employs managers from Turner Investment Partners and, since January, Diamond Hill Capital Management, which also runs the recently closed Diamond Hill Small Cap Fund /zigman2/quotes/203131214/realtime DHSCX +2.60% .
Constellation Small Cap Value is a "consistent performer," Smith said. "If you want to go up -- to make sure you don't miss the upside -- this fund will put you there."
Small-cap funds under the radar
Source: Morningstar Inc. (Data as of 4/3/06)