The InvestMentor

May 7, 2003

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Two weeks ago, in my column appraising the prospects for small cap stocks, I made one of my famous sweeping statements, all too typically devoid of empirical support. As is often the case, I can count on my loyal readers to keep me honest. To wit, I've been asked to explain my affinity for small cap growth stocks in this market.

My outlook for small cap growth is predicated on the notion that my oft-repeated economic outlook continues to unfold as expected. That is, that the economy continues to grow, picks up pace later this year, and is eventually characterized by renewed investment in capital equipment and technology. Serendipitously, the market rises as well, making 2003 the first good year for stocks in a loooonnnnngggg time. (Can I get an "Amen"?!).

There are three reasons for why I believe small cap growth to be a likely winner over the other three market styles, large cap growth, large cap value, and small cap value.

First, in the prospective market environment described above, investors' appetite for risk increases dramatically, as it always does when stocks are perceived to be on the rise. During a bear market, investors seek out the stability of large companies. Small cap stocks represent greater risk to investors. Greater volatility, greater insolvency risk, great earnings variability. If investors deem the market and economy to be on an upswing, they'll venture back into the surviving small cap, fast growing companies in search of market-beating returns.

Second, small cap growth has lagged its peers until recently. Each of the styles are plotted below, relative to each other.

If you believe, as I do, that the market is made up of various cycles, all driven by properties of momentum and mean-reversion, than you believe that any style can't stay out of favor forever, and when it's hot, it's hot. In fact, when a style goes from being out-of-style, to in-style, its a good sign and bodes well for the coming two to three years. That's where small cap growth is now.

Finally, small cap growth does best in this economic environment—one emerging from recession. Technology companies heavily populate the small cap growth universe. Using the Nasdaq as a proxy for all tech stocks, investors are favoring them over the broad market this year, as the Nasdaq is doing better than twice as well as the S&P 500. But the same rationale applies outside of tech. An improving economy increases the viability of smaller, fast companies. All good for the stock prices of said companies.

In addition to having a meaty helping of small cap growth stocks in my portfolio, I've also taken a ride on the back of an Exchange Traded Fund that tracks small cap growth: the Russell 2000 Growth iShare, ticker IWO. ETFs are dandy ways to play out a style bet. The IWO is a basket of small cap growth stocks that trades as a single equity, and it eliminates the risk that individual stock selection interferes with the small cap growth movement.

Copyright © Redside Media, LLC. All Rights Reserved. Nothing in this article is to be construed as advice to buy or sell any security. The InvestMentor is William L. Valentine IV, CFA, President of Valentine Ventures, an investment management firm of individuals' assets.