Buy American

When people talk about "the market," they usually mean the Dow Jones Industrial Average of 30 large-capitalization stocks, most of which trade on the New York Stock Exchange. A few might be referring to the Nasdaq Composite Index, and a tiny fraction might mean the Standard & Poor's 500, another familiar index of large-capitalization stocks.

But despite the "tough market" reflected in these widely followed indexes, there are a number of stocks posting enviable returns these days — and many of them are traded on the American Stock Exchange. Long the ugly stepsister to its more fashionable (and better marketed) counterparts, the Rodney Dangerfield of stock exchanges is finally deserving of a little respect. And with the big favorites continuing to get crushed, it couldn't have come at a better time.

If they're familiar with it at all, most people know of the Amex for its dominance in ETFs, or exchange-traded funds. The exchange first listed the SPDR (SPY) S&P 500 exchange-traded fund back in 1993, and over 100 different ETFs now trade there, accounting for over 75% of daily volume.

But in its rush to list new ETFs, the Amex has ironically overlooked one based on its own Amex Composite Index, which has quietly turned into the sleeper index of the new millennium. The American Stock Exchange Composite is exactly what its name suggests — an index based on the value of all the stocks traded on the exchange. Over 700 companies, including a smattering of ADRs, real-estate investment trusts and closed-end funds, all trade on the Amex.

And despite the fact that most people can't name a single stock traded on the exchange, the American Stock Exchange Composite has often outperformed the Dow, Nasdaq and S&P 500 over the last one-, two-, three- and four-year time periods. Over the last 12 months, for example, both the Amex Composite and Dow are down about 3%, vs. drops of 50% for the Nasdaq and 18% for the S&P 500. Year-to-date, the Amex is down roughly 2%, vs. drops of 3% for the Dow, 9% for the S&P 500 and 19% for the Nasdaq.

A great deal of the index's strength can be traced to its diversified constituency, and specifically to its relatively small weighting in tech. According to Morningstar, over 20% of the total market value of the S&P 500 comes from technology stocks; by contrast, only 4.14% of the Amex's total market cap is tech. Technology has also been a drag on the Dow, which since the November 1999 addition of Microsoft (MSFT) and Intel (INTC) has become more closely correlated with technology shares.

But the tech weighting isn't the only difference. The Amex Composite also includes a larger percentage of natural-resource and energy companies than the other major indexes. Energy accounts for only 7% of the capitalization of the S&P 500, but well over 15% of the Amex's; the index's second- and third-largest members are Devon Energy (DVN) and Imperial Oil (IMO), which account for 5% and 10%, respectively, of the Composite's total capitalization.

Along with energy, tobacco hasn't been too shabby a sector either as of late, and it just so happens that the largest listing on the American Stock Exchange is British American Tobacco (BTI), weighing in at 16% of the total index. Also worth noting is the Amex Composite's smattering of REITs. The Morgan Stanley REIT index is up 14% in the last 12 months, and according to the National Association of Investment Trusts, the average mortgage REIT is up almost 70%. Anworth Mortgage Asset (ANH), Capital Alliance Income Trust (CAA) and Apex Mortgage Capital (AXM) are among those in the sector that trade on the Amex. While REITs do trade on other exchanges, their outperformance isn't reflected in the major indexes. There are no REITs in either the Dow Jones Industrials or the S&P 500, and only 16 of the 130 publicly traded REITs trade on the Nasdaq.

Another factor in the Amex outperformance is the exchange's focus on small and midsized companies, both of which have beat the pants off the large caps in recent months. Market cap refers to a company's total market value. While formal definitions vary, small-cap stocks are usually those with a market cap of below $1 billion. Midcaps have market caps between $1 billion and $5 billion, and large caps weigh in at $5 billion-plus. Giant caps sport market caps of $25 billion or more.

Out of the approximately 700 companies listed on the Amex, only 25, or about 3.5%, have market caps over $1 billion. The vast majority are either small caps or midcaps, making the Amex not just an exchange that lists small-cap and midcap stocks, but in essence, a small-cap and midcap exchange.

In sharp contrast, over half of the S&P 500 are giant-cap stocks, and another one-third large caps. Less than 1% of the S&P 500's total value is composed of small-cap stocks, once again raising the question we first broached early last spring: How diversified is that S&P 500 index fund?

The absence of small-cap stocks is being felt within the increasingly popular index products now available. You're not going to see small caps' strong performance reflected in the actively traded Nasdaq 100 Index Trust (QQQ), or "Cubes," that can be found in so many people's portfolios. That's because the Cubes track the Nasdaq 100, the 100 largest stocks by market cap, not the overall Nasdaq Composite. What difference does that make? Well, while the Nasdaq Composite is down 20% year-to-date, the large-cap-centric Nasdaq 100 that most of us own is actually off over 30%.

In short, the Amex Composite Index has been in the sweet spot as of late. It boasts a diversified assortment of smaller-cap stocks, along with a heavy weighting in tobacco and natural resources. But want to go long the index in your portfolio? Fat chance!

Let's say you wanted to buy the S&P 500. You could buy the Vanguard 500 Index fund (VFINX). You could buy the Fidelity Spartan U.S. Equity Index fund (FUSEX), the SSgA S&P 500 Index fund (SVSPX) or the Munder Funds 500 Index fund (MUXAX). In fact, there are no fewer than 95 open-end mutual funds that focus on the S&P 500. There are dozens of exchange-traded funds that focus on large-cap equities, including the "Spider" and iShares S&P 500 (IVV), which specifically track the S&P 500. Big dogs can trade both the full-size S&P 500 futures, their "mini" counterparts or any one of the thousands of options contracts linked to the highly popular S&P 500.

The Nasdaq is equally tradable. The Nasdaq 100 is consistently one of Wall Street's most actively traded securities, and there are 12 other exchange-traded funds that offer exposure to the Nasdaq, including the Fortune e-50 Index fund (FEF), streetTRACKS Morgan Stanley HighTech fund (MTK), iShares Goldman Sachs Technology Index fund (IGM), iShares Dow Jones US Technology fund (IYW) and Technology Select Sector SPDR fund (XLK). There are literally thousands of technology mutual funds and over a dozen that specifically focus on the index's 100 largest stocks. In short, there's no shortage of ways to go long the Nasdaq, if you so desire.

Even the Dow is easy to get into these days. The Diamonds fund (DIA) is an increasingly popular exchange-traded fund that tracks the Dow almost tick-for-tick, and a host of mutual funds also provide easy exposure. The Burnham Dow Focused 30 fund (BUROX), Potomac Dow 30 Plus Inv fund (PDOWX) and TD Waterhouse Dow 30 fund (no snapshot available) are all based on the ubiquitous average.

But the Amex? Forget it. There are no exchange-traded funds, open- or closed-end mutual funds, options, futures or warrants pegged to the American Composite, a decision no doubt based partly on the exchange's relative lack of liquidity. An active day for Amex-traded Nabors Industries (NBR) is 3.7 million shares, while Nasdaq-listed Cisco Systems (CSCO) will trade that in the first 15 minutes.

But that doesn't mean you can't use the Amex to make money. Instead of buying an Amex Composite ETF, you can learn from the trends that have particularly benefited the index in recent months.

1) Think Small
Still obsessed with Oracle (ORCL)? While the rest of the world complains about how terrible the market has become, check out the Wilshire Microcap Index. It's up over 19% year-to-date, and more than half of the stocks on the Amex can be found in this increasingly popular benchmark. Microcap funds aren't just outperforming the broad market, they're kicking major butt in their own right.

Among them, Bridgeway Micro-Cap Limited (BRMCX) has enjoyed a 24% gain year-to-date, thanks in part to one of its top holdings, the Amex-listed Holly (HOC), which is up 65%.

Franklin MicroCap Value (FRMCX) is up over 35% this year, and its second-biggest holding is Amex-listed Delta Apparel (DLA). With only a $45 million market cap, the stock is up over 35%. And Amex-listed NVR (NVR) is the second-largest holding in Ken "Back-From-the-Dead" Heebner's CGM Focus fund (CGMFX). Both the stock and his fund are up about 35% year-to-date.

2) Play the Sectors
As I noted, the three largest stocks in the Amex Composite Index are tobacco and energy concerns, and while these sectors have pulled back in recent weeks, they've shown encouraging relative strength. British American Tobacco is a high-dividend stock that I'd consider buying at these levels, and if I was ever going to buy a "dip," I'd pick up an appropriately sized position of Nabors Industries, the energy concern whose price has been halved since May 1.

3) Play the Pessimist
For all its standout performance, the Amex is, let's face it, Wall Street's equivalent of a lousy neighborhood, a place many inhabitants are hankering to move away from. And while it's a depressing thought for exchange executives, Amex pessimists might simply buy a portfolio of the index's five largest companies, anticipating an exchange-related "pop" when they finally do decide to move to the vastly more glamorous NYSE. For example, Viacom (VIA.B) was up sharply in the weeks before it moved from the Amex to the NYSE, as were Hasbro (HAS) and Cablevision Systems (CVC). All three defected from the Amex in 1999.

In terms of researching the exchange and its denizens, an Amex spokesman assures me a revamped Web site is in the works. For now, interested parties will have to settle for Amex.com and Americanstocks.com, both which feature search engines capable of analyzing exclusively Amex listed stocks.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund. At the time of writing, Hoenig's fund was long or controlled shares of Anworth Mortgage.