From the November 1997 issue of Entrepreneur

Everyone knows bigger is better. Bigger houses and bigger cars are signs of bigger paychecks and bigger success. The stock market has echoed this theme, with the large companies housed in the Dow Jones Industrial Average and Standard & Poor's 500 (S&P 500) racking up, well, really big gains for the past two years. Actor Tom Hanks could tell you that "Big" was good for him. But as comedian Steve Martin once put it, maybe now's the time for everyone to get small . . . small-company stocks, that is.

At first glance, the question seems academic. Why should investors abandon what seems to be a sure thing to embark on what could be a volatile and risky relationship? After all, for the 12 months ending April 1997, the total return of the Russell 2000, an index of small stocks--also known as small caps--lagged behind the S&P 500 by a big 20 percent--the second-worst trailing-two-month performance in the history of the index. But Claudia Mott, director of small-company research at New York City-based Prudential Securities Inc., a full-service brokerage firm, notes that now could be the time to take the plunge. "Historically, the average return for the Russell 2000 in the six-month period following substantial trailing-12-month underperformance is well above 20 percent," says Mott. "Although many of these periods overlap, there have been only three subsequent six-month periods in which the small caps underperformed the S&P Composite." Yet the question remains: Should small stocks be a part of your portfolio?

Share the wealth

Why small companies now? In addition to their relatively poor recent past performance, several trends make this sector attractive. Many investors, tired of watching their small-company stock values decline while large-company shares hit new highs, have redeemed shares in small cap mutual funds to switch to the big guys. This selling pressure has forced fund managers to liquidate shares, dropping stock prices still further. Outflows seem to have ceased, however, replaced by new money being invested in a sector that seems undervalued. This inflow of funds has somewhat stabilized the price of some of the top small cap stocks and led to an increase in mutual fund share prices.

The recently passed capital gains tax cut should also benefit small caps. While stocks tend to be sold off in response to a cut in the capital gains tax rate, the reaction is often short-lived. Small cap stocks have tended to do well when rates fall, as evidenced in the late '70s and early '80s, when their performance outshone that of their larger cousins. On the other hand, when rates have risen, small stocks have underperformed large ones. Strong economic earnings have been positive for small caps, recessions negative. Most economic soothsayers see smooth sailing ahead, a good sign for small companies.

Finally, comparisons between the prices of large- and small-company stocks show the latter to be a bargain at today's prices. Currently, small cap stocks appear to be one of the last relatively cheap alternatives in a market that has soared beyond most investors' wildest expectations. The case for small companies strengthens.

Baby steps

On the surface, the case for small caps looks good. After all, history tells us that over time, small caps outperform large caps, right? Although past performance is not an indication of future returns, a study done by Ibbotson Associates, a financial consulting and software firm in Chicago, shows that hypothetical long-term investors in small-company stocks had a lot to be happy about. Assuming reinvestment of all dividends and capital gains, one dollar invested in 1925 in small cap stocks would have been worth $4,495.99 at the end of 1996. The same dollar invested in large cap stocks would have grown only to $1,370.95.

Even if small caps do outperform large caps over time, the ride is anything but smooth. With the possibility of higher returns comes higher risk; while some small companies may rocket into outer space, others have been known to come back to earth with a sickening thud. "Yet anyone who's not about to retire should have some small cap exposure," says Mott. "If you're going to buy a [small cap] fund, you should hold on to it. People have lost some of their investment by trying to get in and get out [too quickly]." The idea is to get in and hold on for the long term.

If you're concerned about taking too much of a risk, consider investing in small caps slowly--invest a set amount monthly in a fund, and do it for the long term. Before you invest, be sure to read the fund's prospectus and review the asset allocation of your current portfolio. Then consider devoting a small portion to small caps. Be prepared for a wild ride; the prices of small caps generally are more volatile than those of large-company stocks.

A little here, a little there

If you prefer to put together your own portfolio of small-company stocks, do so cautiously. Unlike the Dow's components, analysts who follow the smaller stocks are few and far between. Information can be scant, too, making it hard to decide not only what to buy but when to sell. Finally, many smaller issues are quite illiquid, making it difficult when it comes to selling shares.

Experts advise sticking with industries you know. If you own a small company that markets computer software, start in the technology industry. Keep abreast of industry trends through trade magazines, and be sure to get a copy of the company's annual and quarterly reports before you decide to invest. Look for companies with good management, little or no debt, high ownership of shares by insiders and a unique niche in an industry. Savvy investors also avoid those companies that have high ownership by institutional investors, like mutual funds. Wouldn't you want to go where the pros go? Definitely, but it helps to beat them to the punch. If the shares of a company you like are thinly traded and few in number, a mutual fund's purchase could cause share prices to rise--enough for you to get out at a higher price.

As an investor in this volatile and risky sector, once you've picked a company, keep your exposure to it small. Unlike large, multinational firms that boast many products and services, the fortunes of a small company may ride on just one product. Problems with production or packaging could put it out of business.

Whatever you decide, don't fall in love with a small-company stock. You may have put tremendous time and energy into selecting and following it, but be alert and responsive when its fortunes change so you can either collect your profits or cut your losses.

Make sure your portfolio is diversified. If you don't have the money to buy stock in several companies, consider a mutual fund.

Small chance

Whether you choose to go the mutual fund route or decide to pick your own small cap stocks, consider the style of investing and the type of companies you're picking. In general, there are two styles: growth and value. Growth companies are those with the highest earnings-to-growth rate. They tend to do well in poor economic times. Some examples of growth industries include food and drug companies. Value stocks are those trading with low multiples of earnings, book value or cash flow. Cyclical companies like paper and trucking firms are examples of value stocks. If you like bargain hunting, value investing is for you.

Which should you go with? Currently, analysts are more in favor of value small caps because of their lower valuation. As of the end of June, the trailing price-to-earnings ratio of the value companies of the Russell 2000 was 18.9 vs. 35.8 for the small-company growth sector. The projected 12-month P/Es are 15.1 and 24.2. Should you plow all your small cap money into value stocks, then? Unless you have a crystal ball, it's still wise to diversify and invest a bit in both sectors.

When it comes to diversifying your investments and getting the most from your money, small-company stocks could add diversity and, over time, help manage your risk. Seems like it's a small world, after all.

Lorayne Fiorillo is a financial advisor and first vice president at Prudential Securities Inc. She presents retirement planning and personal finance workshops worldwide. For more information, write to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614. All figures are courtesy of Prudential Securities. Past performance is no guarantee of future returns.