Small-Cap Stocks Poised For Big Comeback
Andrew Leckey

Consider the upbeat scenario: An improved economy reinvigorates consumers, who run out to buy pairs of new shoes.

While that is an oversimplified example of cause and effect, it depicts the basic logic behind some of the good prospects for small-cap stocks. They were hammered in 2008, regained momentum in 2009 and show promise for 2010 based on hopes of a better economy.

Small-cap value funds are up 64 percent over the past 12 months and small-cap growth funds up 52 percent, according to Lipper Inc.

One company beneficiary: Popular casual footwear company Skechers USA Inc. (SKX), which has performed well despite a tough economy, saw its stock gain 129 percent last year and is up 21 percent this year.

Flexible in adapting to trends, Skechers is expected to pick up sales and profits in an economic recovery because its brand identity is so strong. Its wide variety of shoe styles are sold primarily to teen-agers and young adults through department stores, specialty stores, online and more than 240 company-operated stores.

"The current phase in small-cap stocks is earnings driven," explained James Collins, CEO of Insight Capital Research & Management Inc. in Walnut Creek, Calif., who recommends Skechers stock. "Across the board you can put together a portfolio of small-cap stocks at very reasonable prices in terms of their price/earnings ratios."

Another small-cap favorite of Collins is data storage firm Xyratex Ltd. (XRTX), which has been posting some good results. It designs and makes data storage systems, while also providing testing, cleaning and handling equipment.

"Information technology is a good sector because so much equipment is so ancient by now," said Collins. "That's why we anticipate a nice pick-up in capital spending for it."

Veeco Instruments (VECO), a top designer of machines that manufacture data storage equipment, semiconductors and solar panels, has a diversified customer base that includes nanoscience researchers, he added. Its cutting-edge tools command 60 percent of that market.

Other small-cap companies Collins considers poised for further success are SXC Health Solutions Corp. (SXCI), a pharmacy benefit management services provider, and Super Micro Computer Inc. (SMCI), a maker of high-performance server components and systems.

"When earnings are driving these stocks, I think that you will find that small-cap growth stocks will outperform small-cap value stocks," predicted Collins.

Nobody should be the least bit surprised that small-cap stocks have been on the rise, according to some expert investors.

Going into recession, larger companies reduce their inventory and scale down, which immediately hurts smaller companies that typically are their suppliers. Credit tightens and the smaller companies have difficulty getting money as well. But when larger companies rebuild their inventories, as they did last year, they go first to their suppliers and that gives a boost to small-company stocks.

"It's a well-known fact that small-cap stocks tend to underperform when going into a recessionary period and then tend to lead during a recovery," said Adriana Posada, a portfolio manager of American Beacon Small Cap Value Fund (AVPAX), which is up 74 percent over the past 12 months to rank in the top one-fourth of small-cap value funds.

One of that fund's most significant holdings is Valassis Communications Inc. (VCI), a producer of newspaper inserts and coupons that has good growth prospects despite a strong run-up last year. With a client list that includes T-Mobile, Geico, Wal-Mart and Verizon, it aims to cross-sell a wide range of marketing products in an attractive package to advertisers.

Another major stock holding is Gentex Corp. (GNTX), whose auto-industry products include rear-view mirrors with cameras in them and automatic-dimming mirrors. It is constantly developing new applications for its technology and its products are no longer strictly for luxury cars, but cars in all price ranges. Unlike many automotive suppliers, it is in excellent financial shape with no debt and lots of cash. It has paid a dividend since 2003.

To some, the prospect of near-term economic improvement isn't the only reason to be in small-cap stocks.

"Regardless of the economic climate, investors should have small caps in their portfolios for their long-term investment strategy," believes Gregg Fisher, president and chief investment officer for Gerstein Fisher in New York. "How much depends on their tolerance for risk, since these stocks are more volatile than their big or mid-cap brothers and sisters."

When buying small-cap stocks, Fisher prefers to go with asset classes in exchange-traded funds rather than try to pick individual stocks.

He favors the iShares Russell Microcap Index (IWC), which tracks the Russell Microcap Index that includes the bottom 1,000 stocks in the small-cap Russell 2000 Index plus an additional 1,000 firms not included in the index. Over time, studies have shown that micro-cap stocks can outperform larger stocks and have little correlation to other asset classes.

Vanguard Small Cap ETF (VB), a broadly-diversified and inexpensive ETF that tracks the MSCI U.S. Small Cap 1750 index, is an excellent way to play small-caps, Fisher believes. It contains the smallest 1,750 of the top 2,500 publicly traded companies in the U.S. ranked by market capitalization.

"If the markets are good at pricing risk correctly, then investors will benefit by owning small-cap stocks in their portfolios," concluded Fisher. "I'm sort of indifferent to the widget that is used."