Small Caps May Still Have Room to Grow

Small Caps May Still Have Room to Grow
Past Decade's Returns Still Short of Historical Average

By Erik Ogard, Portfolio Manager
Russell Investment Group
May 22, 2006

The small-cap Russell 2000® Index has notched several all-time highs in recent weeks further highlighting an eight-year bull market among the smallest stocks in the United States.

Some investors see this as a sign that the bull market is ready to expire, or that the pendulum has swung too far already.

However, a closer examination suggests that today's highs may not be excessive; room for growth might remain.

The Russell 2000, which measures publicly traded companies with market capitalization of less than $5 billion, has regularly notched new highs in recent months, but small caps have essentially been playing catch-up with large-cap stocks over the past six years. The large-cap Russell 1000® Index reached an all-time high on March 24, 2000 when it was 233% ahead of its 1995 level. Over the same time, the Russell 2000 was only 130% ahead of its 1995 levels.

In the six years since, small caps have edged higher and higher while large caps remained relatively flat from 2000 to today.

Small Catches Large Over 10 Years
Earlier this year small caps finally edged ahead of their larger brethren when measured over the past 10 years. On April 24, the Russell 2000 was 206% ahead of its 1995 level whereas the Russell 1000 was 192% ahead.

But just because small caps have pulled slightly ahead does not mean they are done growing in this market cycle.

Judging by figures from Ibbotson Associates, which date back to 1926, small-cap stocks historically have earned 12.4% a year against 10.7% annually for large-cap stocks.

But right now, the figures show that over the past decade small caps have advanced at about the same rate as large caps. Since 1996, the Russell 1000 has grown at 9.75% a year and the Russell 2000 has grown at an annual average of 9.2%.

The figures therefore put small caps below their historical annual average of 12.4%.

Based on these statistics, some investors might revise their views and conclude that — based on the historical returns — small caps have a ways to go before they are exhausted.

Keep in mind that small-cap investments are subject to considerable price fluctuations and are more volatile than large-company stocks. Investors should consider the additional risks involved in small-cap investments.

Small Cap Swing to Growth
An even closer look reveals another dimension. Most of the small-cap gains over the past six years have been in value stocks. The Russell 2000® Value Index averaged a 17.4% yearly advance from April 24, 2000 to April 24, 2006. The Russell 2000® Growth Index advanced only 1.2% a year over the same time.

If small caps have room to grow, therefore, that growth might take place in growth stocks rather than in value stocks.

Of course, the markets are always subject to unforeseen economic events and forecasting expectations based on historical averages isn't certain. It is possible that small caps may fall soon. But investors who invest according to such a theory and sell small caps might lose out should they continue to climb.

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Growth investments focus on stocks of companies whose earnings/profitability are accelerating in the short term or have grown consistently over the long term. Such investments may provide minimal dividends which could otherwise cushion stock prices in a market decline. Stock value may rise and fall significantly base, in part, on investors' perceptions of the company, rather than on fundamental analysis of the stocks. Investors should carefully consider the additional risks involved in growth investments.

Large capitalization (large cap) investments involve stocks of companies generally having a market capitalization between $10 billion and $200 billion. The value of securities will rise and fall in response to the activities of the company that issued them, general market conditions and/or economic conditions.

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Russell 1000® Index: Measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market.

Russell 2000® Index: Measures the performance of the 2,000 smallest companies in the Russell 3000® Index, representative of the U.S. small capitalization securities market.

Russell 2000® Growth Index: Measures the performance of those Russell 2000® Index securities with higher price-to-book ratios and higher forecasted growth values, representative of U.S. securities exhibiting growth characteristics.

Russell 2000® Value Index: Measures the performance of those Russell 2000® Index securities with lower price-to-book ratios and lower forecasted growth values, representative of U.S. securities exhibiting value characteristics.

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This is a publication of Russell Investments. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

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