Big Profits in Small Packages

Never underestimate the little guy. Investors often dump shares of small companies at the first signs of trouble: They’re perceived as riskier than behemoths like Wal-Mart or IBM. But small-cap stocks are often the first to perk up when confidence improves—leading the charge in 12 of the past 15 bear market recoveries.

With signs emerging that the economy’s free fall was nearing an end, manager Mark Coffelt made a 180-degree turn in his Empiric Core Equity fund. Just a year and a half ago, he had been shorting, or betting against, small stocks. Now, however, he has ratcheted up his exposure to small caps to 44 percent. He’s not alone. After sliding 60 percent since their peak in 2007, small stocks have seen a big run-up of late. The Russell 2000 index is up 46 percent since March. But some experts with an eye on historical stock charts say there’s much further to go. After the 1980 and 1982 downturns, for instance, small stocks rebounded with 71 percent and 98 percent gains, respectively, within 200 days of hitting bottom. Citigroup Small/Mid-Cap U.S. Equity Strategist Lori Calvasina points to other signs the rally could go further, such as increased merger activity and rumblings of a rebound in initial public offerings.

To be sure, this recession is a lot different from those in the recent past, and there may be a pullback before further gains. Typically, small caps take a much more severe drubbing than larger firms. But with the epicenter of this crisis lying with banking behemoths, the S&P 500’s slide was almost as bad as the Russell 2000’s. And the severity of the credit crunch suggests that even when conditions improve, lending will be cautious; since smaller firms have always had more difficulty accessing credit than bigger companies, financing in the postcrisis years may be even tougher. Smaller firms also don’t trade as frequently as larger stocks. With investors still smarting from the pain of getting stuck in illiquid assets during the downturn, it’s possible some may stay away from smaller stocks, limiting their upward momentum.

That’s one reason Chris Wallis, manager of Natixis Vaughan Nelson Small Cap Value fund, thinks it pays to be more selective than in past recoveries. Wallis is focusing on companies with little debt and high return on assets and avoiding areas that are heavily dependent on credit, like real estate investment trusts and financial stocks. “If you have a clean balance sheet, it’s a great time to make money,” he adds.

Lately, Allison Thacker, managing director of RS Investments’ growth team, is finding gems within technology. Many of these companies, like Internet firm Akamai, pair the sought-after traits of the little guys—like their quick reactions to new innovations—with the best elements of larger firms, such as lots of cash and little debt, she says. Smaller firms also allow investors to tap into hot trends directly; no matter how innovative a business of General Electric’s may be, you won’t see those gains quickly reflected in the conglomerate’s share price. And with even the optimists expecting paltry economic growth for the U.S. in the near term, Thacker says the hunt for companies that can grow from catalysts like clean energy or increased Internet traffic, even as the economy plods along, will intensify. That hunt is increasingly leading managers to small, nimble firms.

Our Picks: Don’t want to search for small stocks on your own? We found four fund managers with good long-term records who are beating their peers so far this year.