Can Small-Company Stocks Continue Their Big Rally Up?

Stock Watch

Can Small-Company Stocks Continue Their Big Rally Up?

The little guys have been outrunning blue chips, and still have a lot going in their favor.

Forget the disparaging remarks about small fry. Stocks of smaller companies are delivering outsize returns these days. Last year, stocks in the Russell 2000 index, a small-company benchmark, returned 27%, trouncing the 15% gain of Standard & Poor's 500-stock index. The small-stock index surged 32% from late August through January 7.

Lest you think this is a rally-come-lately, know that there's been no lost decade in the land of small companies. Small stocks rose 6.3% annualized in the ten years that ended in 2010; the S&P 500, just 1.4%.

Small stocks still have a lot in their favor. Start with expectations of continued economic strength in the U.S., fueling impressive earnings growth. Standard & Poor's expects earnings from operations to jump 33% in 2011 for the companies in its SmallCap 600 index, compared with just 13% for S&P 500 blue chips.

A pickup in mergers and acquisitions will help, too. There were more small-company deals in 2010 than in the previous two years combined, and the trend should continue this year. Look for announcements among industrial and health-care companies -- that's where you'll find clean balance sheets, plenty of cash and lots of talk about the urge to merge, say analysts at Credit Suisse.


Former bond investors could also boost small stocks if some of the money flowing out of bond funds ends up in small-stock mutual funds. That started to happen in December.

Is the timing off for those switch-hitters? There are signs that small-stock dominance is waning. "Small caps have outperformed large caps in nine of the past ten years. But even Mickey Mantle went through batting slumps," says Sam Stovall, S&P's chief strategist.

Clearly, small stocks aren't the bargains they once were. Some analysts think prices are nearing extremes. If earnings expectations turn out to be too optimistic -- a real possibility -- then small stocks could go from fairly valued to overvalued in a heartbeat. Plus, history shows that 60% of the time, small stocks take a back seat to large stocks in the third year of a bull market. This one began in March 2009.

Analysts at Credit Suisse believe that big stocks will lead the market starting in the second half of 2011. But that doesn't mean you should abandon the little guys. Credit Suisse still expects returns of 10% to 14% this year. Stocks on the brokerage's "buy" list include marketing firm Quinstreet (symbol QNST, $22 as of January 7) and restaurant chain Ruby Tuesday (RT, $15).


Steven DeSanctis, of Bank of America Merrill Lynch, sees high-single-digit returns this year and thinks the best prospects are for stocks of companies with earnings growing faster than average (as opposed to stocks that are cheaper than average). Look for opportunities in high tech, health care and energy.

Investors who make real money in small-company stocks are patient enough to hold promising small stocks until they grow into larger ones, says Henry Ellenbogen, who manages T. Rowe Price's New Horizons Fund. "Our competitors turn over holdings every eight or nine months; we do so every four to five years." (For more on small stocks versus blue chips, see The Problem with Owning Blue-Chip Stocks Now.)