The poor performance of smaller-company stocks has been receiving a lot of attention these days and some of their supporters are ready to throw in the towel.
Examining the record, they might have good reason to do so, because these so-called smaller stocks, some in companies with sales under $50 million a year, have trailed the gains made by the big brand-name companies since 1983.That performance casts much doubt on a thesis held dear by some stock market analysts, that smaller stocks tend to produce stronger gains than the very largest stocks.
The belief received strong academic support in 1978, when Rolf Banz, a University of Chicago researcher, traced the relative performances for 50 years and found that the idea wasn't just in the imagination but in the numbers too.
A variety of explanations were offered in subsequent years to justify the findings, including the obvious one, that smaller companies tend to grow faster than larger ones.
Banz, however, found that even after accounting for the greater risk there was a small-stock premium.
The theorists then pointed out that the largest stocks were so closely examined by so many analysts that just about everything was known about them. Therefore, the market was efficient in respect to such stocks.
Smaller stocks are not closely followed and so tend to be less efficiently priced. With smaller stocks there always are surprises. A stunning bargain might be found simply because the word hasn't gotten around.
That sounded plausible. Also containing the ring of truth was the assertion that large institutional buyers, the big pension and mutual funds and their kin who support the blue chips, are too large to buy into smaller companies.
Too large? Yes, because it is inefficient for them to buy the small amounts of stock that smaller companies have available.
To illustrate: They can buy a few million dollars in shares of General Motors without greatly affecting the price, but a smaller company probably wouldn't even have that many shares available. Moreover, such purchases would distort the price. The smaller company simply couldn't accommodate them.
Many other possibilities also were offered, but now there is a tendency to dismiss the entire thesis.
Smaller stocks, it is said, have been so well discovered that their market is now efficient. Moreover, while huge institutions still cannot invest in them, mutual funds have been created just for that purpose.
But hold on, says former Professor Gerald Perritt, now proprietor of Investment Information Services, a Chicago research and investment advisory firm that is widely recognized as an authority on small-business stocks.
Perritt stakes his reputation on the idea that the small-stock premium still exists. He contends that the poor performance since 1983 is understandable, in view of the earlier runup in prices for the small-stock sector.
From 1975, when the small-stock affect was attracting attention, to about mid-1983, when the premium was most noticeable, the per share prices of smaller companies rose several times more than per share prices of blue chips.
By then, the smaller company stocks were overpriced, says Perritt. They had attracted so much attention that investors had bid them beyond their true value. A lot of the earlier investors wanted to take their profits.
At the same time, a different pattern developed among individual investors. More and more during the 1980s they chose to invest through conventional mutual funds. Traditionally, these funds invest in blue chips.
Enormous sums flowed into these mutual funds, and pension funds too, and they and other institutional investors put the money into blue chips, pushing up prices and making the small companies appear even more laggard.
Meanwhile, Perritt found that the small-stock premium never was consistent. "The excess returns provided by these stocks tend to run in streaks, the last of which began in 1975 and ended in 1983," he says.
Since then, so many smaller stocks have been ignored that he believes they might be underpriced. Time for another streak, he says, adding:
"Given the stones being cast at small-firm stocks, this sector of the market is a contrarian investor's dream."