Small wonders: Why small-company stocks are outperforming the S&P 500 and Dow this year

NEW YORK — You may be unfamiliar with some of the best stocks on Wall Street this year.

Small, mostly unknown names are leading the surge in stock markets. Companies like Entravision Communications, a Spanish-language media company; SunPower, a maker of solar panels, and MannKind, a biopharmaceutical company, have more than tripled in value. All are part of the Russell 2000, an index of small-company stocks that has outperformed other major indexes in 2013.

The Russell 2000, as its name implies, includes about 2,000 companies with a market value ranging from $129 million to $3.3 billion. The index broke through 1,000 for the first time on July 5 and closed Friday at 1,048. It has jumped 23 percent this year. That's better than the Standard & Poor's 500 index, which is up 19 percent, and the Dow Jones industrial average, which has gained 18 percent.

The Russell's performance is even more impressive over the past 4-1/2 years. The index is up 205 percent since a bull market in stocks began in March 2009; the S&P 500 is up 150 percent.

That suggests investors are slightly more comfortable buying stocks of smaller, riskier companies, than they are holding shares of big, multinational companies, like Exxon Mobil and Apple.

The S&P 600, another index that tracks small-company stocks, is also reflecting the popularity of small caps. That index is up 24 percent this year.

Investors have poured a net $18.2 billion into small-company mutual funds this year, according to Lipper, a company that tracks funds. If that trend continues, the sector could have its best year since 2004, when investors put a net $20.8 billion into small-company funds.

MORE RISK, MORE RETURN

Typically, small-company stocks are riskier investments than larger companies. The companies tend to be relatively young; it's harder for them to raise money to expand; and they are more vulnerable during downturns because they aren't as diversified as big companies.

But in times of economic growth and rising stock markets, like now, demand for small-company stocks goes up because investors are more comfortable taking on risk.

And small companies can reward risk-takers with bigger returns. The S&P 500 has risen 22 of the last 30 years. In those years when the broader market gained, the Russell outperformed the S&P 500 about 64 percent of the time. The index's best year was 2003, when it soared 45 percent, compared with 26 percent for the S&P 500.

Investors, however, do need stronger nerves to own small-company stocks. The Russell has fallen 10 times in the past 30 years while the S&P 500 has declined six (one year it finished unchanged).

BETTER GROWTH

In an economy that is expanding slowly, rather than powering ahead, many companies are finding growth hard. When corporations finish reporting second-quarter results, revenue for companies in the Standard & Poor's 500 is forecast to have declined 0.6 percent compared with the second quarter of 2012.

But smaller companies entering new niches can grow quickly.

Digital marketing is one area of strong growth as smartphones and tablet computers soar in popularity. The majority of Americans now own a smartphone of some kind, according to a survey published by the Pew Research Center on June 5. Smartphone adaptation among U.S. adults has climbed to 56 percent from only 35 percent two years ago.

Responsys, a software firm that creates marketing campaigns for social networks and smartphone users, saw revenue rise by 25 percent in the second quarter as demand for its services increased. The company's stock has risen to $14.90 from $5.96 at the start of the year, a gain of 150 percent.

ACQUISITION TARGETS

Higher growth rates make some small companies tempting acquisitions for larger rivals, who can boost their revenue growth by absorbing them. Many of the big gainers in the Russell this year are acquisition targets. The reason? Big companies often pay a premium to acquire a company. When investors think a deal may be coming, their buying boosts a small company's stock price.

In June, Salesforce.com, a cloud computing company, agreed to buy ExactTarget, a digital marketer similar to Responsys, in a $2.5 billion deal. Salesforce paid $33.75 for ExactTarget's outstanding stock, a premium of more than 50 percent. ExactTarget's stock had climbed $3.09, or 16 percent, to $22.10 in the five weeks before the Salesforce bid was announced.

Another example is Gannett's acquisition of Belo.

Gannett, which owns USA Today, said on June 13 that it was acquiring Belo in a deal that valued the Dallas-based TV broadcaster at $2.2 billion. Gannett agreed to pay $13.75 a share for Belo's outstanding stock, 28 percent more than the company's market price.

Entravision is also benefiting from higher advertising revenue and from refinancing its debt, says Kupinski. Its stock has climbed to $5.86 from $1.66 at the start of the year, a gain of 253 percent.

So far this year, 51 companies listed in the Russell 2000 have been snapped up. The pace of acquisitions, at about seven companies a month, is higher than has it's been since 2007.

U.S. FOCUS

All stocks in the Russell 2000 are U.S.-based, and that's helped the index. While economic growth in the U.S. has been tepid so far this year, it has been better than some other developed economies, particularly in Europe. The U.S. economy is faring better because the housing market is recovering and hiring is picking up. The U.S. economy will grow 1.7 percent this year, according to projections by the International Monetary Fund. The economies of countries that use the euro are forecast to shrink by 0.6 percent, led by Italy's 1.8 percent contraction.