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.
Further rate reductions are expected and will be necessary to sustain a small-cap turnaround, noted Pradhuman, who believes that this expectation is already priced into the equities of smaller companies.
A 4.25 percent funds-rate target by April, implying another 50 basis-point reduction, is a "high probability," said Steven Ricchiuto, chief economist at Chicago-based ABN AMRO Chicago Corp. A three percent year-end goal is "not out of the question," he speculated.
Given that the health of the IPO market is predicated on favorable valuations in the secondary market, a continued turnaround could ultimately stimulate demand for new offerings.
"In order to see the equity markets bounce back, we needed to stabilize the financing process through the debt markets," Pradhuman said.
Leading Charge
Riding the "rubber-band" effect to the fullest extent, companies in industries perceived to be the most economically sensitive were the quickest to bounce back in the market's latest rally.
Coming off a seasonal summer lull, as well as showing signs of beating the Asian flu, the semiconductor industry led all industry groups surveyed for this story. The 12 semiconductor participants that debuted within the last year climbed to an average return of 45.82 percent over offering, from 3.65 percent a month earlier.
"I think there has been a strong shift in investor psyche," said Charlie Galvin, an analyst at investment-banking giant CS First Boston. "We have seen some signs of recovery, and investors didn't want to miss out. When the semiconductor industry turns, it turns big."
Glavin attributed the shift to expectations for a seasonally-strong fourth quarter, as well as the availability of additional capital from mutual funds at the beginning of the quarter.
But despite the favorable outlook for the industry over the long term, Glavin and others believe investors may have acted a bit prematurely.
"In the short term, we think investors may have overreacted," Glavin said. "We think it's going to be a good seasonally-strong quarter, but not as robust as people are expecting."
Ken Pearlman, an analyst at New York-based CIBC Oppenheimer, also questions the staying power of investors if the industry's newfound vitality is unable to carry through the next seasonally-slow period, which began this month.
"I expect things to slow down in December," he said. "The question becomes, how will investors react if the slowdown continues into March?"
Beneficiary
Because of the intangible nature of its business and the lack of catastrophic events, the insurance sector was also one of the principal beneficiaries of a healthier economic outlook.
"The macro-economic environment has become less of a concern," noted Alice Schroeder, who follows the industry for New York-based PaineWebber. "The small caps were hit a lot harder than the large caps were."
Stirling Cooke Brown Holdings Limited (Nasdaq:SCBHF) led the insurance group, climbing 43 percent to close the end of October at 17 7/8 a share on the wings of a favorable economic climate and news its board had authorized the repurchase of up to 250,000 shares.
The Bermuda-based company priced last November through a Goldman, Sachs & Co.-led syndicate at $22 a share.
