Tasty Little Guys

Wall Street analysts are not exactly an endangered species. But their numbers are in steep decline, and that's great news on two levels: it's wonderful payback for all the bogus advice many of them gave in the late '90s, and more important, it offers new advantages for investors who like to fish for bargains among the stocks of small companies.

Fewer analysts means less stock research on small companies (market value under $1 billion), no matter how good the companies may be. If you know a good thing when you see it say, among firms whose products and services you have used and admired you have a better shot now at investing ahead of the pack. And here's the bonus: we're in the rising phase of the economic cycle for small companies. So if you're not a stock picker, just put some cash in a small-cap-stock mutual fund, and let the tide lift you up.

Where have all the analysts gone? Many have been laid off amid heavy cost cutting at brokerages. Others have left out of fear that new rules barring analysts from lucrative investment-banking activity will cut deeply into their earnings potential. Just a few years ago, Citigroup had enough analysts to cover nearly 1,200 companies; today the firm covers fewer than 800, and most of the stocks dropped have been those of smaller firms. The number of analysts covering large companies like Cisco and eBay is rising.

This big-company focus is understandable. That's where most brokerage clients have most of their stock-market money. It's also unfortunate because small stocks tend to beat large stocks coming out of a recession. In the 12-month period following the end of each of the past 10 recessions, small stocks rose an average of 28%, vs. 19% for large stocks, according to fund company T. Rowe Price. In only one instance (1961) did large stocks beat small stocks after a recession and it was by the slimmest of margins, 14% vs. 12%.

Why does this pattern occur? Small companies are more focused domestically, and typically the U.S. is the first to emerge from a global slump. Small stocks also tend to get hit hardest in a recession as investors move to the safety of blue chips, so small stocks have more room to bounce back as the recovery takes hold and investors broaden their holdings. "When you are coming out of a tough economy and off a market bottom, the cyclical recovery in earnings tends to be strongest with small caps," says Jack Laporte, president of the T. Rowe Price New Horizons fund. Some of his favorite holdings are retailers (Ann Taylor), business services (Exult), software (Jack Henry) and semiconductors (Maxim Integrated Products).

The pattern of small-cap outperformance appears to be holding this time around. The recession probably ended 18 months ago, and on cue, small stocks have outperformed the overall stock market since then. If you're thinking it might be too late to buy them, it isn't. Small stocks are 20% cheaper than large stocks, based on historical price-to-book and price-to-sales comparisons, says Steven Desanctis, director of small-cap research at Prudential Securities. Small-cap funds have seen inflows the past two months after outflows in March. So momentum is building, and we have not yet seen much of the typical boost from large companies' buying small ones as the recovery gathers steam. Desanctis likes retailers, tech, biotech and energy.

To keep things simple, consider a low-expense, blended index fund like Dreyfus Small Cap Stock Index, a top performer (up 2% a year the past three years). That will give you diversification, including value and growth stocks. For a more pointed approach, lean toward top-performing small-cap growth funds like Buffalo Small Cap (up 9% a year the past three years) and Liberty Acorn USA (up 8% a year). They're more leveraged to a recovery without which small stocks of any kind are a bad bet anyway.