Joe Dancy writes for the Lone Star Growth Investor newsletter. The newsletter is free of charge and is delivered to subscribers via email on a regular basis. For additional subscription information, you may visit their web site at: http://members.aol.com/LSinvestor

September 5, 1998

Microcaps - those companies with a market capitalization of less than $100
million - have fallen on average of more than 50% from their 52-week highs,
according to small-company stock guru Bill Nasgovitz, the President of
Heartland Funds. By comparison, before this weeks sell-off the average large-
cap stock with a capitalization of more than $20 billion is off only 16% -
significant, but not the devastation seen in the micro-cap sector.

With the tremendous loss of market value in the micro and small-cap sectors,
the question for the individual investor is whether something has happened to
change the long term value of companies. For reasons set out below, we think
nothing has materially changed, and we continue to find these companies
attractive.

SOME EXPERTS SEE REBOUND
Nasgovitz said a small-company stock bear market began last October and
predicted it will end later this year. "This is a small-cap rout," he said,
and noted that this is as "bad as its been" this decade. Redemptions from
small-cap mutual funds are forcing fund managers with low cash levels to sell
shares. "The valuations just get cheaper and cheaper. In 1990, small stocks
fell 22 percent, including a 30 percent plunge between mid-June and the end of
October.

He believes 1999 will see a strong rally in small-company stocks. "We're
seeing insiders buying twice as much as they're selling," he said. "I think
the catalyst is going to be the Fed cutting short-term interest rates."

Salomon Smith Barney analyst Keith Mullins said small-cap shares since April
have suffered one of the "worst declines in history." Mullins claims that
small-cap stocks should outperform larger companies as the market recovers,
since they have been disproportionately bludgeoned on the way down. When
investor fears about Asia subside "the approaching period of outperformance
will be much stronger, and sustained considerably longer, than most can
possibly imagine." (See: http://www.canoe.com/FPNews/sep1_meltdownma.html)

Claudia Mott, small cap expert at Prudential Securities, notes that small cap
valuations "are amazing." Much of the data she looks at goes back 19 years,
and many of the financial ratios are lower and more attractive than they were
"at any other past low points like the recession of 1990."

For Ken Kailin, manager of the Principal Preservation Select Value Portfolio,
the slide in small-cap stocks is creating a big opportunity. "I feel like a
kid in a candy store," said Kailin. A small-cap value manager, Kailin believes
the time is nearing for small-cap stocks to be revived. "I'm very bullish on
the small-cap market for the long term . . . we're on the verge of small-cap
stocks outperforming."

Once the impact of Asia's financial crisis on American corporate earnings
becomes clearer - Abby Joseph Cohen, the Goldman, Sachs market guru, said she
expected that to happen in "the next few months" - a long-term investor with a
stomach for the gyrations of small-cap stocks may find that now is a good time
to think small. She notes that the stage has been set for small caps to
outperform their larger peers, which are more exposed to foreign markets.

LONG TERM OUTPERFORMANCE
Long term, statistics indicate small-caps have historically outperformed.
Ibbotson Associates Inc. found that over the past 72 years, small-caps have
averaged a return of 12.7% a year, compared with 11% for large-caps. That is a
huge difference in the long term. One dollar invested in 1926 in small-caps
was worth $5,500 at the end of last year; one dollar in large-caps was worth
$1,800, according to Ibbotson.

But with loftier returns comes higher volatility. Small-caps have a standard
deviation of 34%, meaning that in two-thirds of the years, their returns range
from minus 21% to plus 45%. Some experts note that volatility can be a measure
of investment risk - and small caps have a much larger standard deviation on
average than larger cap stocks. By contrast, the standard deviation for large-
caps is 20%, giving them a range, two-thirds of the time, from minus 9% to
plus 31%.

Recently, small caps performance has lagged. Big-caps beat small-caps in 1995,
1996 and 1997 as well. In fact, the outperformance was quite striking. Over
the past 3 1/2 years, small-caps have returned a total of 93%, but the large-
caps of the Standard & Poor's 500-stock index have returned 168%.

If you buy into the mathematical concept that events tend to "regress to the
mean," small caps may return at some point to their historic valuation and
performance levels. "Regression to the mean" applies in all sorts of areas:
extremely wet years are generally followed by ones that aren't quite so wet;
economic booms tend to give way to busts; really, really tall people have
children who grow up to be not quite so tall as their parents.

We think the most convincing explanation for the current plight of small-caps
is that the market simply favors certain sector in its cycles. This is a
large-cap time, but, at some point small-caps will perform so that they
"regress to the mean." Long-term investors can afford to wait, and add to
positions at the depressed valuations now.

SMALL & MICROCAP VALUATIONS
Beth Dater, portfolio manager of Warburg Pincus Emerging Growth Fund, says, "I
think this is an excellent time to buy good-quality small companies -- and I
mean excellent -- for investors who can take a three to five-year view."

Dater expects small companies in the Russell 2000 to have earnings growth of
around 25 percent, compared with 8 percent to 10 percent for the S&P 500, and
a wide gap is expected next year. "Earnings drive stock prices over time,"
Dater said, "and the expectation must be that, in time, that will be true
again."

Small caps are cheaper relative to large stocks than they have been since the
market downturn of 1990, said Satya Pradhuman, director of small-cap research
at Merrill Lynch. Ken Kailin agrees and notes that small-cap stocks as
measured by the Russell 2000 Index are the cheapest they have been to large-
cap stocks relative to that index since it was introduced in 1979. The Russell
2000 Index measures the performance of 2,000 small-cap companies. Companies in
the Russell 2000 small cap index have an average market capitalization of $790
million - a small cap, but not microcap, index.

Contrarians know that a good way to find attractive investments is by "mining
the laggards." It's a decent bet that one reason a sector has fallen behind is
that the market may have overreacted to external events - like Russia and
Asia. Currently it has become too enthusiastic about large-caps and too
pessimistic about small-caps, as money floods into the market - much from
overseas.

Academic research shows clearly that buying undervalued stocks is a successful
investment strategy. James O'Shaughnessy writes in What Works on Wall Street
that "Buying high PE [price/earnings] stocks . . . is a dangerous endeavor.
You shouldn't let the flash of the latest glamour stock draw you in to paying
ridiculous prices for earnings."

Studying the market between 1951 and 1994, he found that high price-to-
earnings stocks returned 9.4% annually, on average, while the S&P as a whole
returned 11.4%. High price-to-book stocks did just as poorly relative to the
S&P, and in both cases risk levels (or volatility, the extremes of stocks' ups
and downs) were higher than for the market as a whole.

INSTITUTIONAL INVESTOR BIAS & FOREIGN MONEY
Some of the strength of the big-caps has come from the $29 billion foreign
investors poured into U.S. equity markets in the first quarter - more than
they put into U.S. stocks in all of 1994, 1995 and 1996 combined. Such
investors are looking for safety, and tend to favor big-company stocks.

Another reason is that institutional investors like the liquidity large caps
offer in an uncertain market. Institutional investors now control about 60% of
the stock in the 1,000 largest U.S. corporations, up from around 46.6% in 1997
according to the Conference Board. Control of these companies is becoming more
and more concentrated among the largest 25 institutional investors - they
owned 19.7% of the outstanding shares in 1997, up from 16.7% in 1996.

Because of these inflows big-caps are now relatively expensive. If the S&P 500
index were a stock, investors in it would be paying about 24 times earnings
for a company that was increasing its earnings just 6% a year. The index has
not sold at a higher price/earnings ratio during the past 100 years according
to some.

Keith Mullins, an equity strategist at Salomon Smith Barney, isn't
particularly bothered about liquidity because he says it is only temporary --
a result of the Asian crisis. He's seen the process before. After the crisis
subsides, he recently wrote clients, "the market's liquidity premium contracts
and smaller-cap issues generally rally."

Mullins believes that small-cap fundamentals are solid. "The fact that [small
stocks] have the ability to deliver stronger earnings growth than the large-
cap indexes for the next 18 months or longer should allow the group to enjoy
more than a simple trading move," he wrote.

FEAR FACTOR
Many investors are scared of small companies because of the wider price swings
in the small-cap stocks. Because small companies are less experienced, less
diversified and less analyzed than blue chips, they are riskier investments.

James Paulsen, chief investment officer at Norwest Investment Management in
Minneapolis, states that "there's greater predictability among large-cap
stocks. In a world of disinflation, there is a valuation attachment for
predictability."

While the markets remain volatile as they digest the economic problems in
Asia, Russia, and possibly Latin America - and tries to digest the political
problems of our President and the problems of leaders in Japan and Russia.

Once these issues are resolved small and micro caps are poised for a
substantial advance.

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