Don't Give Up on Small Stocks

These days, it seems that nearly everyone is recommending large- company stocks. The big boys, according to many analysts, have attractive valuations, and the recovering economy should improve their prospects. But some pros are loath to dump the group of smaller stocks that have trounced the broader market for years.


Indeed, while the Standard & Poor's 500 index was up 13 percent in 2010, small and midsize stocks gained nearly twice that. Over the past two decades, small- and midcap stocks have produced an average annual return of 14 percent, while the S&P 500 has returned an average of 11 percent annually, according to FactSet Research Systems. And some portfolio managers say there's still plenty of opportunity in the small and midsize outfits. Smaller stocks tend to outperform their bigger cousins at the beginning of periods of economic expansion. It's easier for niche companies to do well right now, experts say, because they're not as dependent on the overall economy to grow, just small segments of it. "We're still in the early stages of the economic rebound," says Craig Hodges, portfolio manager of the $64 million Hodges Small Cap fund. Plus, some smaller companies remain attractive takeover targets for big firms with lots of cash but few growth prospects.

Of course, there's more risk with small and midsize firms. Their stock values tend to move considerably faster—both on the way up and the way down—than large firms. Most don't have as much cash as big firms, so a downturn could hurt them harder and more quickly, analysts say. The small stocks aren't cheap, either. Thanks to their big rally, they trade at an 11 percent premium compared with large firms. Historically, they trade at an average 2 percent discount, according to market research from The Leuthold Group. The stellar performance of small-caps and midcaps for so long has led many strategists to wonder if their heyday is over; Goldman Sachs, for one, sees the S&P 500 gaining 23 percent this year. "Large-caps are the most attractive cap sector right now," says Will Muggia, portfolio manager of the $840 million Touchstone Mid Cap Growth fund.

But Hodges says smaller companies that are well managed and are increasing earnings at a faster clip than sales remain attractive. Men's retailer Jos. A. Bank ( JOSB: 46.11, -1.18, -2.49% ) , for example, has been able to open stores and unveil new clothing lines even as others have cut back. Analysts also like Luby's ( LUB: 5.35, -0.05, -0.92% ) , a cafeteria chain that bought a larger restaurant outfit, Fuddruckers, out of bankruptcy. The business isn't growing much, but Hodges says Luby's management has a track record of turning businesses around. In the financial sector, credit card company Discover Financial Services ( DFS: 21.75, -0.07, -0.32% ) intrigues some pros. The firm, considerably smaller than its rivals, recently bought The Student Loan Corp. and could become an acquisition target for a large bank, says Don Wordell, manager of the $1.6 billion RidgeWorth Mid-Cap Value Equity fund.