February 12, 2004, 8:37 a.m.
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Hang some small-caps in your portfolio.

Small is beautiful. At least that's what they believe in San Francisco, where a couple of weeks ago I was roaming one of my favorite neighborhoods. A few blocks away is City Lights Bookstore, the Beat Generation hangout; nearby on Kearney is America's greatest Chinese restaurant, the dumpy little House of Nanking, where pea shoots are in season; and over on Montgomery is Japonesque, where gorgeous glass sculptures that look like rippling fish ponds will, with some justice, set you back many thousands of dollars.

But it's late at night, my plane has just landed, and everything is shuttered except a restaurant on an alley with a little neon sign. I am dining with Michael Moe, who is rhapsodizing about the "most innovative, fastest-growing companies in America." Mainly, small ones. Moe is the founder and chief executive of ThinkEquity Partners, and he peddles his enthusiasm in the lowest of keys in this dark boîte, crowded even on Sunday night.

San Francisco is back. The investment-banking firms that, along with venture capitalists farther down the peninsula, funded much of the Silicon Valley boom and brought scores of high-tech companies public in the 1990s, have largely disappeared, merged away or reorganized out of existence. But the bankers and the analysts themselves have resurfaced in newer, happier, and wiser firms.

The great progenitor of this new movement is Tom Weisel, who headed Montgomery Securities and left, after Bank of America bought it, to form his own firm, Thomas Weisel Partners, which lately has been handling financings for companies such as Netflix (NFLX), the online DVD-rental service, and FormFactor (FORM), which has some kind of advanced semiconductor technology that I can't begin to understand.

Moe, who made a reputation by recognizing great for-profit education companies, such as Apollo Group (APOL), before anyone else, also came from Montgomery, and so did Craig Johnson and the other top managers at JMP Securities, whose analysts follow 160 companies and whose bankers managed 19 public-equity offerings last year.

Yes, San Francisco remembers The Bubble, but it still believes in small-caps — and, after my visit here, so do I. For three reasons:

First, as Moe says, smaller companies are where the growth and innovation are. (We'll get back to this in a second when we meet a former high-school history teacher.) Second, small-cap and large-cap companies tend to move in multiyear cycles, when one sector outperforms the other, and we're now in the small-cap part of the cycle.

Last year — when the small-caps of the Russell 2000 index returned 47 percent and the large-caps of the Standard & Poor's 500 stock index returned 29 percent (both figures include dividends) — was the fifth in a row in which small-caps beat large-caps. Similar streaks have occurred between 1938 and 1945, 1963 and 1968, 1974 and 1983, and 1991 and 1994.

Yes, the small-cap cycle is getting a little long in the tooth. Byron Wien of Morgan Stanley reminded clients recently that "the current cycle . . . has already lasted about as long as the average run for these stocks," which is about five years, and that "the best time to buy small-cap stocks is at the bottom of a bear cycle or the trough in an economic recession." Right now, we're in the third year of an expansion.

Also, the valuations of small-caps — for example, their price-to-earnings (P/E) ratios — were low in the late 1990s compared with high-flying large-caps. Now, they're almost back to normal. Still, it's not wise to fight momentum, and small-caps are on a roll that could match that glorious 1974-83 period, when they rose 867 percent, compared with 175 percent for large-caps.

Third, small-caps are benefiting from market inefficiencies. According to efficient market theory, at any moment all publicly available information is reflected in a stock's price. It's the "right" price and, from today's perspective, the price will move in the future in a "random walk," a journey you can't predict.

But, as super-investor Warren Buffett has written, "Observing that the market was frequently efficient, [the theorists] went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day." In other words, a smart investor can often find inefficiencies — or bargains — in mispriced stocks.

Moe believes that small-caps are far less efficient than large-caps because investors and analysts pay far less attention to them — so all possible information doesn't get built into the price. The efficiency disparity between small- and large-caps has always existed, but Moe argues that it has gotten wider.

One reason is that money has poured into index funds, which are mainly based on the large-caps of the S&P 500. Those bigger companies, more than ever, are the focus of attention, so they are less likely to carry "incorrect" prices.

The other reason is that major investment firms have cut back on research after the recent corporate scandals, which forced reforms that separate investment bankers from analysts. Perhaps those reforms will make research more accurate (I have my doubts), but they have certainly made it less plentiful. "Currently," writes Moe, "90 percent of the Nasdaq companies and 60 percent of the NYSE companies that are below $1 billion in market cap . . . have zero research coverage." For investors looking for bargains among small-caps, that's very good news.

The morning after my supper with Moe, I went to the financial district to call on Irene Hoover. Years ago, she was teaching history in Winchester, Mass., when a friend introduced her to the stock market. She left her job, became an analyst, and then a portfolio manager. In 1997, the mutual fund she ran — Jurika & Voyles Mini-Cap — had the best three-year record among all general stock funds.

In her glory, she left to start her own fund. Why? At the time, Business Week explained, "In a word: style. Hoover acted as a lone wolf, researching and tracking most of her own picks, rather than relying on ideas coming out of Jurika & Voyles's research department."

Today, with help from a small staff of analysts and traders, she manages Forward Hoover Small-Cap Equity Fund (FFSCX). Over the past five years, the fund has returned an annual average of 7.8 percent — compared with a slight loss for the S&P. She has easily whipped the small-cap benchmark as well — and at below-average risk levels, according to Morningstar.

Hoover's strategy is to identify what she calls "baby blue chips," companies with strong niches and solid balance sheets that allow them to "self-fund" their growth. In other words, they use their own profits, rather than debt, to invest and prosper. Hoover also insists on reasonable valuations. Morningstar calculates that the average P/E ratio of the 90 stocks Hoover owns is 21 — about one-third lower than average for the market.

For examples of current baby-blue chips, start with Furniture Brands International (FBN), which manufactures furniture under such brand names as Broyhill, Thomasville, and Lane. The company had a rough 2003 because of weak demand for high-end furniture, but it is coming back strong. Earnings have grown at an average of more than 16 percent for the past five years and should continue in the double digits. The stock pays a nice dividend (a yield of 1.6 percent), the company's cash flow is strong, and debt levels have recently been cut. Shares trade at a P/E, based on expected 2004 earnings, of just 12.

Obviously, Furniture Brands is not the kind of go-go tech stock that's usually associated with the Bay Area. Hoover doesn't care. Her fund doesn't specialize in particular sectors. Instead, she looks for stocks that are out of favor, and right now tech stocks tend to be a little too popular.

One recent success has been Sotheby's Holdings (BID), the auction house whose stock was crushed after a price-fixing scandal and subsequent lawsuits. "The uncertainty is behind the company," says Hoover. "We bought it at 9, and it's now 14."

Another winner is Williams-Sonoma (WSM), the San Francisco-based chain that sells stylish cookware and owns retailers Pottery Barn and Hold Everything. The stock has risen by half in the past year, and, while it carries a P/E ratio of 27 (a bit below average for the market as a whole), that valuation does not appear lofty when you recognize that the company's profits have increased at an annual average of 31 percent over the past 10 years and, according to Value Line, are projected to rise 20 percent annually for the next five. Williams-Sonoma is a classic baby-blue chip, easily funding its own growth with a powerful flow of cash and just $25 million in debt.

Much smaller (at a market cap of $600 million) and more obscure is Central Garden & Pet (CENT), which makes and distributes products for the pet, lawn, and garden market. "This company is local," Hoover told me, "and we owned it years ago and then sold it. The company has rebuilt itself." Central has stayed off analyst radar screens. Earnings are growing swiftly and are expected to be $2.47 per share this year, a forward P/E of just 13.

I like the way Hoover runs her fund. Diversification is important with volatile small-caps, and few stocks ever make up more than 2 percent of her portfolio. She manages the fund to keep taxes low (Morningstar ranks it as one of the most tax-efficient small-cap funds), balancing sales of winners with sales of losers. Her shareholders have been responsible for paying taxes on a total of less than 50 cents in capital gains over the past five years — a tiny amount for a fund with a net asset value of about $16. There's no load (or sales fee), but the annual expense ratio is 1.8 percent. In this case, it appears that you get what you pay for.

Forward Hoover is certainly not the best-performing small-cap fund of the past five years. That honor — at least as of most recently — goes to Bridgeway Ultra-Small Company Fund (BRUSX), which last year returned 88 percent and since 1999 has gained an average of 34 percent annually. Manager John Montgomery was runner-up in Morningstar's competition for domestic stock manager of the year. Unfortunately, his fund is closed to new investors.

Still, we can peek at the portfolio. Top holdings at last report included Hi-Tech Pharmacal (HITK), which makes pharmaceutical products such as DiabetiSweet for people with diabetes; Jos. A. Bank Clothiers (JOSB), moderately priced business wear; and Bank of the Ozarks (OZRK), based in Little Rock. All of these companies have market caps below $500 million, and the average for the fund is just $205 million.

Small-caps are fine, but don't get carried away with funds that buy the smallest of the small. Last year was an exceptional period for micro-cap stocks. The Standard & Poor's 600 stock index, which tracks micro-caps (defined as the bottom quintile, or one-fifth, of the 3,000 top U.S. stocks listed by size), returned 67 percent last year. That's abnormal.

For a more conventional small-cap fund that you can actually buy, Bob Carlson, editor of Retirement Watch, one of my favorite newsletters, recommends T. Rowe Price Small-Cap Stock (OTCFX), with a five-year average annual return of 10.8 percent and an expense ratio of 1 percent. The portfolio is huge — 247 stocks, with none accounting for more than 1.5 percent of assets. Top holdings are SCP Pool (POOL), a wholesale distributor of swimming pool supplies, and Kronos (KRON), which makes software for businesses, mainly to do payrolls and scheduling.

If you are looking for something racier, check out Coolcat Explosive Small Cap Growth Report, the best-performing small-cap newsletter, according to the scorekeepers at Hulbert Financial Digest. Coolcat recently recommended Deltathree (DDDC), a company that sells products and services for the hottest new Internet application, VoIP, or Voice Over Internet Protocol. The company is losing money, but Coolcat, which is based in Sanger, Calif., not too far from San Francisco, has high hopes.

In the end, the appeal of small-caps is this: They return more than large-caps (by about 2 full percentage points annually, on average, since the 1920s). But higher returns always come with higher risk. You need small-caps in your portfolio, but don't go overboard. Between 10 and 20 percent of your equity assets will do. The San Francisco enthusiasts want you to be on the high side, and I'm not arguing.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com . Of the stocks mentioned in this article, he owns Apollo Group. This article originally appeared in the Washington Post.

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