Small-cap stocks: Are they worth the risks?

NEW YORK — Investors who managed to remain calm during Wall Street's latest tempest could find they have what it takes to invest in small-cap stocks.

While they often outperform many of their larger rivals, small-capitalization stocks tend to show more volatility. And it often requires the hand of a deft investor to pluck the sound picks from amid the shaky ones.

This year hasn't been easy for small-cap investors. The concerns about bad mortgage debt, tightness in credit and the overall economy that have battered that rest of Wall Street have leaned somewhat harder on small-cap stocks. The Russell 2000 index of smaller companies is down 11 percent for the year, while the Standard & Poor's 500 index, which tracks large-cap companies, is off about 9.4 percent.

Mark Crennan, who works as a markets analyst, said he doesn't worry about the size of the companies he invests in with his own money but that when he does look at small-caps now he is more closely examining their balance sheets. With the credit markets having dried up compared with only a few months ago, it's more important than in years past for small-cap companies to be on sound financial footing. That's partly because companies that could once grow by gobbling up rivals are now finding it harder and more expensive to tap into the credit markets.

Small-cap companies often show bigger moves than the rest of the market on sizable up or down days. Crennan noted that there is no guarantee that smaller stocks will snap back and outperform larger issues as they did for much of the first part of the decade.

Jonathan Vyorst, portfolio manager of the Paradigm Value Fund, said while many investors flock to bigger companies for safety during economic slowdowns, such moves are now less appealing because so many investors have already shifted their holdings to favor bigger names.

Vyorst, who helps run the small-cap value fund with about $113 million in assets, said there are bargains to be found for investors who can stomach the outsize ups and downs that many small stocks show.

"Right now there are plenty of companies you can find that are selling at dirt-cheap prices that require you maybe to put up with volatility for a half year or year. Their values are real. Nobody makes money in this business without being very conscious of what the valuation of the stock is and what they're paying for it," he said.

And of course not all small-cap names are poised to move higher should the economy begin to show signs of recovery. Wall Street's glum mood in recent months shows that few investors are expecting a quick turnaround in the economy.

"It's definitely a spotty market because there is a tremendous amount of volatility," he said. He said some small-cap companies are at levels well above what their profit levels justify, while others are cheap by comparison.

"This is clearly a stock pickers market," he said. "There are plenty of good small-cap companies out there that have been cut in half. It's going to be a tougher time but that's how you make your money."

Stephen Wood, senior portfolio strategist of Russell Investments, is cautious about small-caps. He notes that the classic situation in which small-cap stocks can do well is when the economy is beginning to climb out of recession. He added that the punishing atmosphere on Wall Street these days doesn't offer investors an ideal time for making significant changes to portfolios, he said.

He cautions investors against making big moves into small-cap stocks given the uncertainty gripping Wall Street over where the economy is headed. "I don't think you should jettison where you are but I don't know that you want to proactively overload in this environment."

Wood said investors looking to make bets should instead search for well-managed operations of any size and be willing to wait for returns.

"The stock market is a very effective mechanism to take money from the impatient and give it to the patient," he said.

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