US smallcap analysts prove best as 'buys' beat 'sells' by 12%

Analysts covering the smallest US equities are proving to be the best stock pickers. Standard & Poor’s SmallCap 600 Index companies with the highest recommendations have beaten the lowest-rated shares by 12 percentage points in the year ended May 31. Over the same period, the S&P 500 shares, most favored by analysts, trailed the worst-ranked companies by 6.2 percentage points, the data show.

Small-stock analysts are more successful because their recommendations tend to influence trading and the companies are easier to evaluate, according to James Paulsen at Wells Capital Management and Eric Marshall at Hodges Capital Management Inc. S&P SmallCap 600 companies trade less than those in the S&P 500, with daily volume averaging 373,240 shares in the past 30 days versus 5.6 million.

 

“With small caps, you’re dealing in a universe that’s less followed, more illiquid, and people move on analyst calls,” said Paulsen, chief investment strategist at Minneapolis-based Wells, which oversees about $340 billion. “With largecaps, it’s your standard problem of herds and contrarian thinking. By the time you give a good case why you’re recommending a stock, it’s already extended. The smart money’s already leaving.”

When S&P SmallCap 600 stocks followed by six or more analysts are ranked by their average rating on May 29, 2010, companies in the top-fifth posted 32 per cent gains during the 12-month period ended May 31, compared with 20 per cent for the bottom-fifth. The case is almost the opposite for larger companies: For S&P 500 equities with 20 or more recommendations, companies with the lowest ratings returned 33 per cent versus 27 per cent for the highest.

MORE EXPENSIVE
The S&P SmallCap 600, made up of companies with an average market value of $870.3 million, rallied 29.7 per cent, including dividends in the year ended May 31, beating the S&P 500 by 3.7 percentage points. The index of smaller companies has led the S&P 500, with stocks averaging $24.6 billion in value, in nine of the past 10 years, sending its price-to-earnings ratio to the highest, relative to the benchmark measure since 1995.

Large-company analysts have failed to add value throughout the bull market that began in March 2009. Through December 31, the most-favored S&P 500 stocks posted average gains of 73 per cent, compared with 165 per cent for their least favorite.

‘INCREMENTAL VALUE-ADD’
“Once you have a company that has 50 analysts following it and 48 of them are a buy, the story is well known,” said Don Wordell, a fund manager for Atlanta-based RidgeWorth Capital Management, which oversees about $48 billion. “There’s no incremental value-add. It’s not a low expectation story at that point. Smallcap is just a different animal in that there can be something very differentiating about that research.”

For every $1 invested in the S&P SmallCap 600 at the beginning of the five years ended May 31, investors would have made 28 cents, while earning 18 cents for the S&P 500, according to Bloomberg data. While small-cap equities have beaten larger companies in the past decade, they can also underperform during periods of market volatility.