by Archie M. Richards, Jr., CFP^®
December 6, 1999

Buy low and sell high, right? Great idea. I invented it myself. Well, small stocks are priced low these days, and big stocks are priced high. Hmmm.

If you want to seem like you know what you're talking about on the subject, you refer confidently to "small caps" and "big caps." Cap stands for capitalization, meaning the total value of a company assigned by all of the buyers and sellers of the stock. To figure capitalization, multiply the stock's current price by the total number of shares owned by everyone, including investors, institutions, and employees. Small caps are the stocks currently valued at a lousy billion-and-a-half dollars or less. Some big caps are valued at dollar figures equivalent to the number of hamburgers sold by McDonalds.

When a stock is priced low, it's low in relation to what?

Thanks. You ask the best questions. The stock is valued low in relation to the company's current and anticipated annual earnings. If the annual earnings are $1 a share and the price is $15 a share, the price/earnings ratio, or PE, is 15, which these days is considered low.

If the earnings are $1 a share and the price is $90, the PE is high. If the company has losses and the price is still $90, the PE is out of this world.

The bad news about small cap stocks is, they tend not to pay dividends, and the price changes are more volatile than those of the big caps. Nevertheless, you'd think that small caps would usually outperform the biggies. After all, small companies are more flexible and can implement decisions more quickly. Their returns from research dollars is greater. The managers are more entrepreneurial and closer to customers. The growth potential of small caps is higher, because they don't already own the whole world, and small cap managements usually own a big chunk of their stock and want to maximize shareholder value.

Despite these advantages, during the 72 years from 1926 to 1998, small cap stocks performed about the same as the big caps, with one exception - the period from the summer of 1974 to the summer of 1983. This was a winning time for the little guys.

Immediately after bear-market, panic bottoms, when investors have lost all faith and hurled their stock certificates out the window, small caps have often performed significantly better than big caps. This was the case in 1974, 1982, and 1990.

But not all panic bottoms initiate a small-cap liftoff - 1997 and 1998, for example. On those occasions, small cap stocks underperformed the big caps. Why, I don't know. Since American and non-American investors are participating more and more in each other's markets, maybe they take interest in the big stocks first. It's less work.

But I do know this: Small cap stocks are now unusually cheap in relation to the big ones. Because of the aforesaid natural advantages of small stocks over the biggies, the PEs of the minies are generally about 10% higher than those of the biggies, ranging between 25% higher (in 1983) to 15% lower (in 1990). Recently, however, the PEs of small caps have plunged to a level 30% lower than those of the big caps.

You're a long-term investor, right? You don't care what the prices do in the short term, right? (Well, they make you throw up once in a while, but at least you're not bulimic.) In the long run, price trends tend to return to the mean. One of the these days, the small caps will enjoy their just deserts.

Say you're an investor in an S&P 500 Index Fund. If so, you've done well. But two stocks (Microsoft and General Electric) constitute fully 12% of the fluctuations of the S&P 500 - a significant concentration. You might exchange part of your money to a small-cap fund.

Selling high, buying low. All in all, it's the way to go.

With poetry like that, the Nobel Prize for Literature is in the bag.