Strategist says
now may be time
to sell high-flying,
small-cap stocks

The Russell 2000 reached
its peak earlier this week

NEW YORK » If you're considering an investment in small-cap stocks, let tolerance for drama be your guide.

If watching your stock lose 20 percent of its value in one day would give you heartburn, small-cap stocks are not for you. If you are unwilling to scour quarterly reports for phrases like "material weakness," they're not for you.

And if you can't sell when a stock's price and outlook are sunniest, this isn't your investment.

Small-caps, loosely defined as stocks with a market capitalization between $180 million and $1.8 billion, have never looked better. The Russell 2000, the broadest small-cap stock index, has nearly doubled since 2002 and on Monday hit 671.74, its highest point since its 1988 inception; it closed yesterday at 663.74.

That's why at least one small-cap strategist suggests now might be an excellent time to sell.

As a class, small caps "seem just a little too high at this point," said Steven DeSanctis, small-cap strategist with Prudential Equity Group.

This is a class of stocks prone to drama. Even the pros have trouble finding middle ground.

For the quarter ended June 30, small-cap growth funds led all U.S. diversified mutual funds in returns, with a 3.77 percent return, according to data provided by Lipper Inc. But two of the three very worst performers were also small-cap funds. One lost 25 percent for the quarter, the other lost 11.79 percent.

Of the stocks in the Russell 2000, seven have been delisted this year alone, including Winn Dixie Stores Inc. and Tower Automotive Inc.

Then there's the Standard & Poor's 600 small-cap index, which is picked by committee to represent the overall market. The S&P 600 is up about 5.4 percent for the year, but the gains aren't universal.

Within the index, 312 stocks are up since Dec. 31, with an average gain of 20.19 percent. But 285 are down, with an average loss of 15.61 percent. (Two stocks are flat and one, TreeHouse Foods Inc., is new this year.)

The increase in small caps isn't uniform, said Howard Silverblatt, equity market analyst at S&P. "You have to be selective about what you're doing."

Prices for the biggest gainers in the S&P 600, including The Great Atlantic & Pacific Tea Co. Inc., Frontier Oil Corp. and Southwestern Energy Co., have more than doubled this year, but the losers, such as Ditech Communications Corp., Napster Inc. and Magne Tek Inc. have been hacked in half.

In the Russell 2000, which closed yesterday at 663.74, the 10 biggest winners have been utilities, energy stocks and two shopping center standards, Panera Bread Co. and Men's Wearhouse Inc. The biggest laggards have been stun-gun maker Taser International Inc. and tech issues, including Gateway Inc.

For a taste of one small-cap loser, consider FindWhat.com Inc., now known as Miva. Its stock has lost 20 percent in one day. It ended 2004 at $17.73 a share and closed yesterday at $5.04.

Findwhat.com sells Internet advertising. It's a rarity among small caps because it does a significant portion of its business in Europe, but its first-quarter profit was erased by currency translations. It's in the process of fixing material weaknesses in its controls. And it's in a patent dispute with a company owned by Yahoo! Inc.

More drama than you can tolerate? If you consider healthier small caps, remember one reason they've done so well lately is interest rates that are still relatively low after a year of increases by the Federal Reserve.

"Think of the difference between IBM and the guy around the street who owns a bunch of restaurants," said Mitch Zacks, portfolio manager at Zacks Investment Management. International Business Machines Corp. can issue new stock or float bonds if it needs capital. If the restaurant owner wants money, "he is financing his growth primarily through bank debt."

The dollar's rebound also makes small-cap stocks look good, Zacks said. Large multinational companies suffer when the dollar strengthens and their goods become more expensive overseas. Small companies that produce and sell in the United States don't usually feel much currency effect.

The one thing working against small-cap stocks are the recent years of very strong performance in earnings growth and price appreciation, he said.