With the first quarter of 2005 in the books, nearly everyone in the mutual fund industry is curious whether this could be the year that large-cap funds finally overtake their small-cap counterparts.
Year-to-date through March 24, small-cap equity funds have returned a negative 3.88%, while large-caps are down 3.48%, according to Lipper of New York. Small-cap growth funds posted negative returns of 5.27%, and large-cap growth negative 5.18%.
These close disparities stand in stark contrast to the trailing one-year returns, where, on a cumulative basis, small-caps have delivered 11.58% and large-caps 6.78%. And for the past trailing two years, small-caps have beaten large-caps even more handily; small-cap funds were up 29.48% in that period; large-caps 15.92%.
"We're in a dead heat," said Andrew Clark, a senior analyst at Lipper. "This quarter seems to be more of a toss-up."
If this isn't a sign of the much-anticipated capitalization shift - some experts have been calling for the pendulum to swing to large caps since 2003 - it's not for lack of underlying fundamentals. While small-cap stock funds tend to outperform large-caps coming out of a recession because interest rates are traditionally low and it's easier for smaller companies to obtain the capital they need to expand, that environment is changing. The Federal Reserve hiked the short-term interest rate another quarter-point last month, marking the seventh time it's done so in the last year, and it's widely expected it will hit 3.75% by the end of the year.
The dollar has also been exceptionally weak, which means big, international companies can make larger profits on exports when they exchange their foreign earnings for greenbacks. There's also the matter of risk; investors tend to gravitate to tried-and-true brand names when they get jittery over something like a presidential election, war or inflation.
But complicating this environment is the fact that the Fed has been careful to hike interest rates slowly, which plays to small companies' favor. Big companies also have a lot of cash on the books, fueling further merger and acquisition speculation, which, again, favors the little guys. Furthermore, uncertainty over new compliance regulations has hit all asset classes, and that promotes hesitancy among investors.
Lipper's Clark, however, thinks the last bear market simply beat the feathers out of the blue chips. "It was a particularly bad bear market," Clark offered. "Large-cap stocks haven't been repaired yet, and maybe this is the year the repair is finished and they can get racing again."
Matt Cunningham, a senior vice president and senior portfolio manager with Pittsburgh-based Mellon Equity Associates, boils it down even further. He thinks that, after five years of small-cap dominance, it's just high time for a mean reversion.
"But our [research] model isn't based so much on that as it is on macro-economic fundamentals - the rising interest rates, the dollar works its way into it. There seems to be reasonable valuation within the large-cap space," Cunningham said.
The model Cunningham's firm uses to determine capitalization trends started to "flash in favor of large-cap" last week, he said.
Bob Mitchell, a fund skipper and managing partner at Radnor, Pa.-based Conestoga Capital Advisors, believes all signs point to a large-cap comeback, but he also says the industry could afford to dig a little deeper into the small-cap segment.
"It's critical to remember that small-cap earnings are still going to be better than large-cap earnings for 2005, and the estimates are that they're better for 2006, as well," said Mitchell, a bottom-up, fundamental stock-picker. "There are still inefficiencies within small-cap, and superior earnings growth is still there."
"There are 4,300 companies that are between $100 million and $2 billion in market cap, whereas large-cap companies comprise a more finite number of names," he noted. "There are a lot of eyeballs looking at those 500 names. There might be 50 analysts covering General Electric, but [among] the small-cap names, there are two or three analysts at most." he said.
Then there's the issue of movement within the small-cap sector itself, where Mitchell predicts a shift from small-cap value to small-cap growth. Through February on a five-year, annualized basis, small-cap value is up 16%, according to the Russell 2000. That same metric has small-cap growth down 7.95%. That's a sort of dominance that can't be sustained much longer, Mitchell said.
"In conversations that we've had with intermediaries, they've indicated that people are seriously looking to move money out of the value camps and into more of the growth-oriented indexes," he continued.
As a small-cap specialist, however, one of Mitchell's greatest concerns right now is Sarbanes-Oxley. He says the new disclosure and compliance rules are putting too much pressure on profits at the lower end of the market.
"On a long-term basis, regulations make it very difficult and very onerous for small companies to raise capital and be in public markets. That's a detriment for small-cap investors in terms of the available pool of ideas to examine for their clients," he said.
It's certainly held up the capitalization shift, Mitchell added.
"Overall, you get a sense that the market is waiting to see how all this shakes out, between all the different trials that are going on and what the end result is going to be with all these CEOs signing off on earnings," he remarked. "Will we continue to see a restatement of earnings? The market doesn't like unknowns. There are some unknowns out there that need to be resolved."
High-Tech Holdout
Clark recommends that asset managers should keep their eyes on technology stocks, which Lipper considers its No. 1 indicator of a large-cap run-up.
"They're kind of the bellwether," he explained. "We looked at data from 2000 to 2003, and we found that on a weekly, monthly and quarterly basis, 80% of the time that small beat large, or large beat small, the indicator was electronic technology."
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