The Rally In Small-Cap Growth Stocks

By Aaron Levitt | February 08, 2012 AAA

It seems like every day there's better news coming out of the United States. Unemployment looks to be finally moving in the right direction, manufacturing output continues to increase and consumers have begun opening their wallets. While there is still plenty of uncertainty, the picture is certainly improving.

As the economy begins to show signs of real improvement, the time could be right to consider overweighting stocks likely to benefit from economic expansion. While the trend has been towards focusing on the large dividend-paying firms, small cap growth stocks could be exactly what the doctor ordered in the expanding economic environment. (For related reading, see An Introduction To Small Cap Stocks.)

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Still Room to Grow
So far this year, small cap stocks as represented by the iShares Russell 2000 Index ETF (NYSE:IWM) are up about 12% YTD and are the fifth best-performing domestic "fund category." However, as the macroeconomic picture continues to improve, analysts estimate that there could be more gains in the months ahead. A new report by Credit Suisse (NYSE:CS) predicts that small caps will rise at least 3% during this current cycle and could see an additional 9% gain by year's end.

The broad measure of small caps currently trades for a forward P/E of around 15, slightly below its historical average. The investment bank points out that small caps tend to underperform when their P/E's are closer to 18. This leaves room for gains. In addition, Credit Suisse points to historical statistics for some additional gains. In years in which the Russell 2000 opens with a positive first month, the index's average full-year gain is near 17%. That jumps to a huge 24% gain when January produces a 7% or better return.

There may be some underlying fundamentals for Credit Suisse's predictions. First, the Federal Reserve is giving smaller firms a present, by keeping interest rates low for an "extended period of time." Low interest rates allow smaller firms to buy more equipment, increase hiring and produce more goods cheaply. Due to their smaller size, all of these things will quickly manifest themselves in small-cap bottom lines and revenue.

Additionally, larger firms flushed with an abundance of cash, have gone on an M&A spree. Faced with the lack of organic growth, analysts predict that the trend of "large buying small" will continue throughout the year, boosting small-cap shares. (For more information, read Valuing Small-Cap Stocks.)

Get Small
With the economies improving fundamentals, it may be time to overweight small cap firms within a portfolio. With around $7.9 billion in assets and a rock bottom 0.12% expense ratio, the Vanguard Small Cap Growth ETF (ARCA:VBK) makes an ideal broad-based choice. The fund tracks 969 different small cap growth firms including miner Royal Gold (Nasdaq:RGLD) and baker Panera Bread (Nasdaq:PNRA). So far the ETF is up around 12% for the year, but could see greater gains as "growth" could win over "value" in the expanding economy. For those willing to add more firepower to their small cap investment, the leveraged Direxion Daily Small Cap Bull 3X Shares (ARCA:TNA) could be used.

Some of the best gains could be had in technology small-caps. The acquisition environment in tech is extremely robust and most recently Oracle (Nasdaq:ORCL) offered to purchase cloud computing HR-software firm Taleo (Nasdaq:TLEO) for $1.9 billion. Analysts point to IT infrastructure software firms like SolarWinds (NYSE:SWI) and TIBCO Software (Nasdaq:TIBX) as potential targets. Tracking all the tech firms in the S&P 600 Small cap index, the PowerShares S&P SmallCap Tech ETF (Nasdaq:PSCT) can be used as a broad play on the M&A activity in the space. The fund charges 0.29% in expenses.

The Bottom Line
Given the improving economic conditions in the United States, investors may want to add a healthy dose of small caps to a portfolio. Already, smaller caps have performed well since the start of the year, but these improving conditions could help boost share prices even further. The previous ideas, along with the iShares S&P SmallCap 600 Index (ARCA:IJR), make excellent choices to play the trend. (To learn more, read Small Cap Research Can Have Big Impact.)

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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