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Will Small Company Stocks Continue to Beat the Market?

- Alan Lavine and Gail Liberman

Small company stocks have led the way in this year's bull market. The Russell 2000, a index of small company stocks, was up over 19 percent at mid-year.

Will the small company stock fund rally continue? Small stocks typically do well when the economy is coming out of a recession.

Lanny Thorndike, manager of the Century Small Cap Select Investment fund, isn't an outright bull. But he is encouraged by the trends. He believes investors will move out of record low-rate fixed-income investments into stocks for better returns. The companies he owns all report net income that are high based on stockholder ownership.

Recently, he has taken profits in financial, health care, energy and consumer stocks. He put the money to work in computer services, software and entertainment. He owns stocks like Pharmaceutical Product Development, which provides product development and environmental testing services. The stock is selling at just 13 times next year's earnings. Meanwhile, earnings are growing at 18 percent annually.

Essential Software provides data integration services to companies. The company has strong balance sheet and plenty of cash. Earnings are growing at a solid clip.

Cato Corp. is a fashion retailer of low-price women's clothing. Revenue is growing at 7 percent annually. The stock pays a 3 percent annual dividend. Earnings are growing at 17 percent annually, but the stock is selling at just 12 times earnings.

Michael Balkin, co-manager of the William Blair Small Cap Growth Fund, believes a summer consolidation will create buying opportunities.

"Longer term, we see more upside potential," he says. "Over the short term, there will be a consolidation. The next big move will be with companies with market capitalizations of around $1 billion. They have lagged behind the smaller companies."

Stocks he has purchased are growing earnings at over 20 percent annually. For example, Guitar Center, the fund's largest holding, owns 100 music stores nationwide and has a strong mail order and equipment rental business. The company has good profit margins, and its two major competitors have gone out of business. Earnings are growing at 20 percent annually.

China.com provides mobile phone services and payroll software services in China. The company has strong cash flow and no debt.


Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).

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