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December 1, 1998

The Rubber-Band Effect

By Stephen Lacey

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  • The Rubber-Band Effect

The small-cap companies that made it to the secondary market before the initial-public-offering drought, and then survived a stock-market hammering, are now participating in an historic rally.

Against a 21.9 percent rebound in the Russell 2000 index of small-cap stocks, the 462 IPOs issued over the 12 months ending October 31 pared their average loss over offering to 9.88 percent, from 16.59 percent for the 12 months ending September 31. The average performance for IPOs issued for the 12 months ended October, 31 was a loss of about 1 percent.

The turnaround has raised hopes that small-cap stocks may finally be on the verge of a sustained rally, closing the valuation gap between small-cap and large-cap stocks.

"We've seen such a major turn in the underlying fundamentals for small-cap stocks that I think this rally is very sustainable," said Thomas Barry, portfolio manager for the Bjurman Micro-Cap Growth Fund.

Extreme Discount

Since the founding of the Russell indexes in 1973, small-cap stocks have never traded at a discount as extreme as what occurred at the end of the third quarter.

According to officials at Frank Russell Company, the administrator of the indexes, the average price-to-earnings ratio, or P/E ratio, for Russell 2000 companies was 13 percent lower than the average for Russell 1000 companies. Historically, Russell 2000 companies have traded at an average premium of 21 percent to their large-cap counterparts.

"An extreme valuation gap is like a rubber band: the further it stretches out, the greater the potential for an eventual bounce-back," said Paul Greenwood, senior research analyst at Frank Russell, in an October 5 report. "The key questions are what will it take to rekindle interest in small stocks, and when will this occur?"

The answer to that question came just days later, when the Federal Reserve Board surprised Wall Street by slicing its federal-funds rate by 25 basis points on October 15, lowering the discount rate to 4.75 percent (and to 4.50 percent on November 17 when the federal funds rate was sliced another 25 basis points.)

In doing so, the Federal Reserve offered corporate America the liquidity that the financial markets have been unable to provide.

According to analysts, the shuttering of the IPO market at the end of August (when there were 563 newly-minted stocks outstanding on a trailing 12-month basis) exasperated an impending credit crunch for many small companies to whom banks are more hesitant to lend capital.

"Thanks to the capital markets, both IPOs and secondaries, smaller firms have been able to find and attract capital," said Satya Pradhuman, director of small-cap research at brokerage giant Merrill Lynch & Co. "Because of the significant correction in share prices of smaller firms, that conduit has effectively disappeared."

Because smaller firms are the most dependent on accessing capital to generate growth, they have historically been the principal beneficiaries of rate reductions by the Federal Reserve.

History of Gains

Since 1954, the discount rate has gone through a period of reduction ten times, and the small-cap market has gained in all but one of those periods, noted Claudia Mott, director of small-cap research at Prudential Securities in New York.

The average small-cap gain during periods of Federal Reserve easing, according to Mott, has been 36.6 percent.