TCS Daily

'Tis the Season for Small Caps?

By James K. Glassman - May 7, 2001 12:00 AM

"Holy Cow!" That's the polite version of my exclamation when I heard that the US economy grew by 2% in the first quarter of this year. This rate of growth is really nothing special, usually not cause for excitement, and not even close to the rapid growth of the late 1990s.

But the stock market, just like politics and relationships, is all about expectations. And nobody but nobody among America's leading economists was expecting 2% growth. The forecasters were talking about little or no growth, and some even expected a real shrinking of GDP.

So what does it mean for investors? It means that we may be talking about a kind of mini-recession or perhaps a "soft landing," meaning that we have a few so-so quarters, but not the prolonged recession that many feared. True, the latest unemployment figures aren't very encouraging, but the recent news on GDP growth suggests that the bad times won't last for long and they won't be that bad.

In general, I believe that investors should ignore economic data. You can't do anything about it; nobody can predict where the economy is heading, and if you're a long-term shareholder quarterly or even annual GDP numbers don't really matter anyway. But if you've got cash to put into the market right now and you're wondering which stocks to buy for long-term capital growth, there's a strong case to be made for small-caps.

In last week's column, I noted that some great large companies are selling at depressed prices. I still like those big techs, and those of you who bought after reading that column like them, too. But new economic data suggest that now may also be a good time to fill out the small cap portion of your portfolio.

Small caps are generally considered to be companies with market capitalizations of $250 million to $1 billion. The market capitalization, or market cap, is the total number of shares times the price of one share, so it represents the total value that investors assign to a company. Prices of small cap stocks tend to be very volatile, so you really, really want to be a long-term holder of these shares. While the long-run return for small caps is a little better than that of large caps, the performance in a given year is totally unpredictable. Small caps tend to under-perform the Dow and the S+P 500 for many years and then go through an explosive period for a few years in which they blow away the large caps.

When do these value explosions normally happen? Jeremy Siegel, author of the modern investing classic "Stocks for the Long Run," notes that the small caps usually thrive as the economy is pulling out of a recession. So if we're going to be turning the corner soon after a fairly mild downturn, this could be a good time to catch the small cap wave.

There are a number of small cap techs that I find intriguing. Noven Pharmaceuticals (NOVN) makes transdermal drug delivery systems. What does that mean? Patches. You've seen ads for nicotine patches to help smokers quit, but there's actually a less known but potentially greater market in similar products to deliver other therapies. Noven makes patches for a range of medical uses, such as delivering hormone replacement therapy and dental anesthesia.

RSA Security (RSAS) is in the business of protecting digital data. Readers who bought Symantec after reading my March 14 column are happily aware of the upside in such stocks. Looking to the long term, it's hard to believe that data security won't be even more important in an age of Chinese hacker attacks, Anna Kournikova viruses and increasing reliance on digital record-keeping.

Xeta Technologies (XETA) is not exactly at the leading edge of American technology, but they have a solid business, manageable debt, and the stock is trading at a very low multiple to earnings, which by the way have a good history of growth. Xeta makes call accounting systems for hotels.

Your portfolio should of course include large, medium and small caps in a range of different industries. The three companies mentioned above are good candidates to be the small -tech companies in your portfolio.

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