By GREG IP and AARON LUCCHETTI
Staff Reporters of THE WALL STREET
JOURNAL
The underperformance of small stocks is reaching epidemic proportions, but anyone waiting for a big catch-up rally could be foiled by a law of basic economics.
New research suggests small-stock performance has suffered and will continue to languish because there is a significantly greater supply of small stocks and much less demand relative to large stocks.
The supply-and-demand dynamics have changed fundamentally in the past 10 years to virtually ensure "there will be no mighty small-cap rally this time," argues a study from investment bank Needham & Co., which specializes in small issues.
"There is a shrinking supply of large-cap stocks and an unlimited supply of small-caps," says John Michaelson, president of Needham Asset Management, who wrote the study along with Needham analyst Stephan Leccese.
A small stock is generally defined as one issued by a company with $1 billion or less in market capitalization, or number of shares outstanding times the price.
The supply-demand balance for stocks has underpinned the overall market's rally the past four years, as stock repurchases and cash acquisitions have taken more stock out of the market than has been added through initial and follow-on stock offerings, and as demand keeps rising as a result of mutual-fund cash, the study notes.
But that dynamic has disproportionately benefited large stocks. "The supply-demand situation is very different for small stocks, and it is very unfavorable," the study says.
In the past 10 years, the amount of venture capital has risen tenfold and venture capitalists are taking companies public faster in order to meet ambitious return targets. Complementing that, Wall Street firms have developed a machine for selling those companies' stock to the public, Mr. Michaelson says, ensuring that "whenever small-cap stocks do rally, there is a flood of supply and any small-cap rally carries with it the seeds of its own destruction."
Indeed, Needham calculates that in 1996 there was a net shrinkage of stock of $127 billion, after new issues, buybacks, mutual-fund investing and cash acquisitions are rolled together, and estimates for large private-investor stock sales and stocks issued for options conversion are included.
But there was a $19 billion net supply of small-company stock -- which the study defines as companies with market value of $500 million or less. In 1997, the net shrinkage of overall stock was $95.6 billion, but small-stock net supply was $9.8 billion.
The supply pressure doesn't come just from initial public offerings. Indeed, Needham concludes that after they go public, many small companies continue to put more stock into the market -- often as venture capitalists or company officers sell some of their stock -- through the exercise of employee options and stock-financed acquisitions. For example, between Netscape Communications' IPO in 1995 and March 1998, Needham calculates Netscape's "float" -- the amount of stock held by the investing public -- rose 147%.
Despite Mr. Michaelson's contention that small stocks as a group aren't about to catch up to Standard & Poor's 500-stock index, he says, nonetheless, "Almost all the great companies of the future are going to come out of the small-cap area."
Not all analysts agree that supply has such a large influence on small stocks' performance. Jia Ye, a senior research analyst at First Quadrant, says the outperformance of large-capitalization stocks has been driven by liquidity concerns, foreign fund inflows and earnings surprises.
Nevertheless, some investors do scrutinize small companies for the likelihood of new share issuance. Hans Utsch, co-manager of the small-cap Kaufmann Fund, says he would rather see a small company with more "free" cash flow that is generated from continuing operations. That makes it less likely that the company "will have to come back to the equity markets," he says. Two of his less-successful holdings in the last few years, PhyCor and MedPartners, needed to offer more shares to raise money.
According to Prudential Securities Inc., the median small-cap company has increased its shares outstanding by 1.3% per year since 1994, compared with an increase of 0.41% per year for larger companies with a market capitalization above $3.2 billion.
Fund flows make a big difference too. This year, investors have grown less eager to put money into small caps, says fund-flow tracker AMG Data Services in Arcata, Calif. In the 12 weeks ended last Friday, cash flowed out of stock funds only once. But small-stock growth funds in particular have suffered net outflows in five out of the last 12 weeks.
Thursday's Market Activity
Small-capitalization and Nasdaq issues got a much-needed boost Thursday, riding strength in the technology and financial sectors to solid gains. But smaller stocks still managed to underperform the broader market, and strategists said the selling in the group hasn't yet exhausted itself. The Russell 2000 Index, reversing a string of nine straight losses, improved 3.31, or 0.78%, to 429.50. The technology-stuffed Nasdaq Composite Index rallied 38.09, or 2.02%, to 1919.58.
A soft second-quarter earnings report from Friendly Ice Cream took 3 7/8, or 32%, off that stock to 8 1/8. NewsEdge also reported disappointing second-quarter results, sending the stock off 2 1/4, or 25%, to 6 5/8.
Accelr8 Technology shares dropped 1 5/8, or 27%, to 4 3/8 after the company said it expects to come in with a fourth-quarter loss. Accelr8 said revenue was off sharply because of lower-than-anticipated demand for its year 2000 software.
Shares of Preview Travel rose 3, or 14%, to 24 7/8. The company reported a second-quarter loss of 39 cents a share, a penny better than analysts' consensus estimate and well ahead of the year-earlier loss of 90 cents.
PSC jumped 1 5/8, or 25%, to 8 1/8. The company late Wednesday reported second-quarter net income of 19 cents a diluted share, compared with operating net of two cents a year earlier. Shares of Radcom improved 1/2, or 13%, to 4 1/2 after the company late Wednesday posted second-quarter net income of six cents a diluted share, compared with two cents a year ago.
Mentor Graphics rallied 7/8, or 10%, to 10 1/8; it earned seven cents a share from operations, compared with net income of six cents a year before, and a penny ahead of analysts' expectations. BancAmerica Robertson Stephens, SoundView and Goldman Sachs upgraded the stock.
Candela moved up 15/16, or 29%, to 4 3/16, as it earned 19 cents a share in its fourth quarter, compared with a loss of 24 cents in the year-earlier period. The company also said it has eliminated the adverse impact on its earnings from its skin-care center.
Graham-Field Health Products added 13/16, or 17%, to 5 9/16 on the New York Stock Exchange. The company named Rodney Price chairman and chief executive, succeeding Irwin Selinger, who resigned. Andrew Giordano, former president and chief operating officer, left the company in June and Mr. Selinger was subsequently named interim president and chief operating officer.
Dialog rallied 2 1/4, or 21%, to 13 1/4 after launching an electronic-commerce business, Planet Retail. On the Nasdaq, overall volume rose to 739.5 million shares from 730.5 million shares Wednesday. Advancing issues led decliners, 2,218 to 1,863. Seven of the eight Nasdaq industry subindexes showed gains, including a 3% rise in the Nasdaq computer index.