Small Packages For diversity-hungry investors, good things come in small cap stocks.

Everyone knows bigger is better. Bigger houses and bigger carsare signs of bigger paychecks and bigger success. The stock markethas echoed this theme, with the large companies housed in the DowJones Industrial Average and Standard & Poor's 500 (S&P500) racking up, well, really big gains for the past two years.Actor Tom Hanks could tell you that "Big" was good forhim. But as comedian Steve Martin once put it, maybe now's thetime for everyone to get small . . . small-company stocks, thatis.

At first glance, the question seems academic. Why shouldinvestors abandon what seems to be a sure thing to embark on whatcould be a volatile and risky relationship? After all, for the 12months ending April 1997, the total return of the Russell 2000, anindex of small stocks--also known as small caps--lagged behind theS&P 500 by a big 20 percent--the second-worsttrailing-two-month performance in the history of the index. ButClaudia Mott, director of small-company research at New YorkCity-based Prudential Securities Inc., a full-service brokeragefirm, notes that now could be the time to take the plunge."Historically, the average return for the Russell 2000 in thesix-month period following substantial trailing-12-monthunderperformance is well above 20 percent," says Mott."Although many of these periods overlap, there have been onlythree subsequent six-month periods in which the small capsunderperformed the S&P Composite." Yet the questionremains: Should small stocks be a part of your portfolio?

Share the wealth

Why small companies now? In addition to their relatively poorrecent past performance, several trends make this sectorattractive. Many investors, tired of watching their small-companystock values decline while large-company shares hit new highs, haveredeemed shares in small cap mutual funds to switch to the bigguys. This selling pressure has forced fund managers to liquidateshares, dropping stock prices still further. Outflows seem to haveceased, however, replaced by new money being invested in a sectorthat seems undervalued. This inflow of funds has somewhatstabilized the price of some of the top small cap stocks and led toan increase in mutual fund share prices.

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

Finally, comparisons between the prices of large- andsmall-company stocks show the latter to be a bargain at today'sprices. Currently, small cap stocks appear to be one of the lastrelatively cheap alternatives in a market that has soared beyondmost investors' wildest expectations. The case for smallcompanies 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 futurereturns, a study done by Ibbotson Associates, a financialconsulting and software firm in Chicago, shows that hypotheticallong-term investors in small-company stocks had a lot to be happyabout. Assuming reinvestment of all dividends and capital gains,one dollar invested in 1925 in small cap stocks would have beenworth $4,495.99 at the end of 1996. The same dollar invested inlarge cap stocks would have grown only to $1,370.95.

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

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

A little here, a little there

If you prefer to put together your own portfolio ofsmall-company stocks, do so cautiously. Unlike the Dow'scomponents, analysts who follow the smaller stocks are few and farbetween. Information can be scant, too, making it hard to decidenot only what to buy but when to sell. Finally, many smaller issuesare quite illiquid, making it difficult when it comes to sellingshares.

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

As an investor in this volatile and risky sector, onceyou've picked a company, keep your exposure to it small. Unlikelarge, 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 ofbusiness.

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

Make sure your portfolio is diversified. If you don't havethe money to buy stock in several companies, consider a mutualfund.

Small chance

Whether you choose to go the mutual fund route or decide to pickyour own small cap stocks, consider the style of investing and thetype of companies you're picking. In general, there are twostyles: growth and value. Growth companies are those with thehighest earnings-to-growth rate. They tend to do well in pooreconomic times. Some examples of growth industries include food anddrug companies. Value stocks are those trading with low multiplesof earnings, book value or cash flow. Cyclical companies like paperand trucking firms are examples of value stocks. If you likebargain hunting, value investing is for you.

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

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

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