Recent rally in small-value stocks will be short-lived

Small-value stocks got a much-needed lift after the Federal Reserve cut interest rates by 1.25 percentage points from Jan 22 to Jan 30.

The recent rally probably won't last. That's too bad because small businesses account for about half of the US private sector's gross domestic product and a little more than half of non-government employment.

Determining what defines a small-capitalization stock depends on the index an investor uses. The average market value of the Russell 2000 Index, a benchmark for US small-cap stocks, is $726 million. That compares with $24.2 billion for the Standard & Poor's 500 Index.

The Russell 2000 fell 8.3 percent through Feb 19, compared with an 8.1 percent decline in the S&P 500. But since small caps peaked last July 13, the Russell 2000 has dropped 18 percent, six percentage points more than its large-cap counterpart. That decline comes after an eight-year run from 1999 through 2006 when small-cap stocks outperformed large caps.

The current small-cap underperformance phenomenon is global. Smaller companies in the United Kingdom, Japan and Europe over the past year have trailed their bigger brethren.

In the United States, small caps got off to a volatile start this year. Through Jan 22, the Russell 2000 fell 12 percent, then rallied 6 percent through Jan 31, propelled by the Fed rate cuts. Still, the 6.8 percent decline for the month was the third-worst January since 1926.

"A weak January doesn't bode well for performance for the full year, as the small caps have delivered below-average returns when the first month has been ugly," Stephen DeSanctis, a New York-based small-cap strategist at Merrill Lynch & Co, said in a recent report.

Nor does the National Federation of Independent Business confidence index, which tumbled to a 17-year low in January to a level consistent with a 3 percent annualized contraction in GDP, according to Bridgewater Associates Inc.

The index portrayed a class of companies beset by weak demand, slowing employment growth, high commodity prices and tightening credit conditions. Smaller companies are dependent on bank loans for their funding, and the Fed's January Senior Loan Officer Opinion Survey found that lenders are tightening their credit criteria. The NFIB small-business survey also showed that the number of companies planning capital expenditures during the next three to six months declined to a 20-year low. Additionally, fewer companies plan to increase inventories.

What's more, small caps are pricey: The Russell 2000 is trading at 40 times trailing earnings, compared with 19 times for the S&P 500.

With less-diversified customer bases and fewer product lines, smaller companies' profit margins usually get squeezed more than those of big companies when growth slows.

Ferragamo SpA Chief Executive Officer Michele Norsa gave the standard answer when asked when the classy, high-priced shoemaker to the stars would go ahead with its initial public offering: "The shareholders will decide when the timing is right, depending on market conditions."

Ferragamo this week announced it had lined up JPMorgan Chase & Co, Mediobanca SpA and UBS AG as advisors on the IPO, in which the Florence, Italy-based company plans to sell a 20 percent to 30 percent stake. Two hurdles: The world economy is slowing, and luxury-goods companies have had a rough ride during the past few months. Bulgari SpA, the world's third-biggest jeweler, has fallen 32 percent from its mid-October highs, twice the 16 percent decline in Italy's S&P/MIB Index over the same period. Meanwhile, Geneva-based Richemont Financiere SA, the No 1 jeweler, has dropped 27 percent from its late October peak, compared with an 18 percent decline in the Swiss Market Index.

And Burberry Group Plc, maker of $3,100 metal-studded Knight handbags, has tumbled 36 percent since early October, four times the drop in the FTSE Index. Bottom line: Ferragamo may be premature in retaining advisers for the IPO. But you can't fault the company for being prepared.

Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.

(China Daily 02/22/2008 page17)