Small-cap stocks require patience

Investors who managed to remain calm during Wall Street's latest tempest could find they have what it takes to invest in small-cap stocks.

While they often outperform many of their larger rivals, small-capitalization stocks tend to show more volatility. And it often requires the hand of a deft investor to pluck the sound picks from amid the shaky ones.

This year hasn't been easy for small-cap investors. The concerns about bad mortgage debt, tightness in credit and the overall economy that have battered the rest of Wall Street have leaned somewhat harder on small-cap stocks. The Russell 2000 index of smaller companies is down 11 percent for the year, while the Standard & Poor's 500 index, which tracks large-cap companies, is off about 9.4 percent.

Market analyst Mark Crennan said he doesn't worry about the size of the companies he invests in with his own money, but when he does look at small-caps now, he is examining their balance sheets more closely.

With the credit markets having dried up compared with only a few months ago, it's more important than in years past for small-cap companies to be on sound financial footing. That's partly because companies that previously could grow by gobbling up rivals are finding it harder and more expensive now to tap into the credit markets. Small-cap companies often show bigger moves than the rest of the market.

Crennan noted that there is no guarantee that smaller stocks will snap back and outperform larger issues as they did for much of the first part of the decade.

Jonathan Vyorst, portfolio manager of the Paradigm Value Fund, said that while many investors flock to bigger companies for safety during economic slowdowns, such moves are less appealing now because so many investors have shifted their holding already to favor bigger names.

Vyorst, who helps run the small-cap value fund, which has about $113 million in assets, said there are bargains to be found for investors who can stomach the ups and downs that many small stocks show.

"Right now there are plenty of companies you can find that are selling at dirt-cheap prices that require you maybe to put up with volatility for a half year or year," he said. "Their values are real. Nobody makes money in this business without being very conscious of what the valuation of the stock is and what they're paying for it."

Of course, not all small-cap names are poised to move higher should the economy begin to show signs of recovery. Wall Street's glum mood in recent months shows that few investors are expecting a quick turnaround in the economy.

Vyorst said some small-cap companies are at levels well above what their profits justify, while others are cheap by comparison.

"This is clearly a stock pickers market," he said. "There are plenty of good small-cap companies out there that have been cut in half. It's going to be a tougher time, but that's how you make your money."

Stephen Wood, senior portfolio strategist of Russell Investments, is cautious about small-caps. He said the classic situation in which small-cap stocks can do well is when the economy is beginning to climb out of recession.

Wood said investors who are looking to make bets should search instead for well-managed operations of any size and be willing to wait for returns.