Six Reasons Small Caps Could Lead the 2009 Rally

| About: iShares Russell (IWM)

Which class of stocks is more likely to outperform in 2009 – small caps or large caps? If big profits are the goal, here are half a dozen reasons to think small.

Which is better for playing the 2009 rally – small caps or large caps?

As a general rule of thumb, “small cap” stocks have a market cap of $1 billion or less. “Large caps,” in contrast, have market caps in the $10 billion range or higher... often much higher.

(Microsoft (NASDAQ:MSFT) and GE, for example, have market caps in the neighborhood of $180 billion as of this writing. Exxon Mobil (NYSE:XOM), the big dog on the block, is worth more than $400 billion.)

Small cap stocks have outperformed large caps for most of the decade, as you can see from the following chart.

$RUT:$SPX (Russell 2000/S&P 500)

From 2001 onward, the small cap stocks of the Russell 2000 Index trounced their S&P 500 peers in relative performance terms.

In 2006 the small cap outperformance trend peaked and stalled... came dramatically back on form in March of 2008... and then declined sharply again as markets fell apart.

Now let’s take a closer look at the same chart (daily view this time).

$RUT:$SPX (Russell 2000/S&P 500)

As you can see more clearly from the above chart, small caps peaked relative to large caps in September 2008.

This makes intuitive sense; as fear gripped the markets and panicked investors dumped shares left and right, the lesser known small cap names were hardest hit.

It appears, too, that the small cap exodus played itself out in late November/early December, as tensions eased and credit began to loosen somewhat.

Get Ready for a Roller Coaster

In the context of what’s next for stocks, John Authers of the Financial Times points out that 2009 could wind up looking a bit like 1932.

In 1932 – the year FDR was elected President – stocks rallied 20% by early March. Then a vicious sell-off took the market to new lows... and then in July a new surge of optimism took hold, leading to 100%-plus gains in just two months. July 1932 wound up registering the all-time Depression low.

So buckle your seatbelt, because there could be some wild trading days ahead.

I think, too, that if we do see a multi-month 2009 rally (or maybe even more than one), small caps could resume their outperformance trend. There are at least half a dozen reasons for this.

Small Cap Edge #1: Scrapping the $10 Rule.

Before the 2008 carnage, many institutional money managers had rules and restrictions on the books like “don’t buy stocks under $10” or “don’t buy stocks under XYZ market cap.”

Those rules made sense in more normal times, when there were plenty of higher-priced stocks to choose from. But now so many names have seen their share prices driven down to bargain-basement levels, the institutional $10 rule could be widely loosened if not scrapped.

On top of that, when animal spirits return to the markets – as they did with a vengeance in 1932 – there will also be a lot of temptation to scoop up the attractive large and mid-cap names that turned “small” by default.

Small Cap Edge #2: More Hidden Gems.

Truly great opportunities are often a result of market distortion. It requires a sustained period of sheer investor panic to create the kind of environment where $100 bills are left laying around on the sidewalk.

The investing equivalent of a $100 bill on the sidewalk is a company whose market cap is trading for less than its unrestricted cash in the bank, or whose lines of business and assets on the balance sheet represent eye-popping values in comparison to the discount Mr. Market has placed on the stock.

Simply by the nature of how Wall Street works, more of these “hidden gem” type opportunities are likely to be unearthed in the small cap arena. Diamonds in the rough don’t get market coverage from fifteen analysts and write-ups in USA Today – it’s much harder to find an edge in names that every mutual fund manager knows by heart.

For this reason, combined with what we just lived through, there could be more value to unlock in lesser known small caps.

Small Cap Edge #3: Survival of the Fittest.

The depths of the 2008 panic were so brutal that many of the weaker small cap players have been carried out. For those companies with too much leverage or precarious lines of business, the freezing of bank credit lines and sharp drop in commerce served as a death knell. This “culling of the herd” has left the 2009 crop of small cap survivors in stronger position.

(Remember, too, that small caps don’t get bailed out by the Treasury or the Fed. You have to be “too big to fail” to enjoy that dubious privilege.)

Small Cap Edge #4: A Crisis at the Top.

Whereas small caps were subject to the Darwinian hand of free markets, many large cap players (particularly in the financials) were bailed out. When Treasury Secretary Hank Paulson spoke of sweeping financial crisis, he was actually talking about the screw-ups of the biggest (and supposedly more sophisticated) players.

The injection of government funds in an effort to save jobs – and to spare the weaker of the “too big to fail” names from a harsh free market verdict – will not do much to enhance future competitiveness on the large cap side.

As Jim Grant points out, the large cap institutions who wake up in bed with the government may find that Uncle Sam has cramped their style, and thus their profit potential, for a long time to come. This could create an opening for scrappy small caps.

Small Cap Edge #5: More Diversity/Less Consumer Exposure.

Many of the large cap behemoths in the S&P 500 got that way by leveraging their exposure to the eighth wonder of the world: the all-singing, all-dancing, all-spending American consumer. For the better part of a quarter century, relying on the consumer to fuel growth was a great play. Not anymore.

Plenty of investors now lick their chops over depressed large cap values in the consumer-linked space, assuming that it’s only a matter of time before the future again resembles the past. But what if the past is gone for good? What if the “structural impairment” of baby boomer wallets is permanent, or at least long-lasting enough to keep the U.S. consumption glory days from ever returning?

If the world has indeed changed, and if adaptability and diversity are better strategies than big consumer-linked playbooks put together over the past quarter century, that reality could again favor the more nimble and diverse world of small caps.

Small Cap Edge #6: Gravity.

If a high-performance motorcycle and a supercharged Range Rover race each other off the line, who wins?

That’s easy – one is 2.8 tons of luxurious bulk. The other is basically an engine strapped to a wheel.

Small caps tend to outperform large caps in periods of expansion for a simple reason: it’s easier to blow the doors off performance-wise when you’re small and light. The more a company bulks up, the harder it becomes to “move the needle” in terms of profit growth.

Small caps could also be the benefactor of aggressive optimism in 2009. If the feeling takes hold that the war on deflation has been won – and just as importantly, that the banks are beginning to lend again – both those factors could act like a turbo-kicker for the motorcycles of the investment world.

In conclusion: if you’re looking for long-term investment opportunities, there are bargains of the decade to be had in overlooked small caps now.

And if you’re ready to ride the 2009 roller coaster for big trading profits, small could still be the way to go.

Stock position: None.