Big Year in Store for Small-Cap Growth

01/10/2011 12:40 pm EST

Focus: STOCKS

James Oberweis

President, Oberweis Asset Management, Inc.

Share prices should grow faster than profits as investors warm to risk, boosting micro-caps and China plays in the process, predicts James Oberweis of the Oberweis Report.

We believe 2011 will be a third consecutive good year for equities, and particularly so for small-cap growth stocks. A consistent message we hear from our portfolio companies is that 2011 will be a better year than 2010. If analysts are underestimating earnings growth potential for 2011, and we believe they are, share prices will increase based on higher earnings alone. But equally important, we believe that there is a decent chance of price/earnings multiple expansion for companies growing at rates much faster than the broader economy.

Valuations for such companies collapsed in 2008; in 2011, we expect the opposite effect and predict that small-cap stock price/earnings multiples will expand. Interestingly, even though high growth small-cap stocks performed extremely well in 2010, prices rose primarily because earnings increased, not because p/e multiples expanded. For example, despite sharp appreciation of our model portfolio, the average p/e multiple of the companies we cover declined from 44 in January 2010 to 25 today.

Fast-Growing Profits on Sale
While lower than last year, today’s level is admittedly higher than the lowest average p/e of 17 observed in January 2009. Over the last decade, however, the average p/e has been 29, implying that present valuations for small growth stocks still remain somewhat below average.

Because of their particularly low valuations at present, the smallest companies in our universe, also known as micro-caps, may offer the best shot for p/e expansion in 2011. Broadly, we are referring to growth companies under $300 million in market capitalization. [Russel Kinnel recently recommended an expense-free micro-cap fund—Editor.]

Inflation Favors Stocks
Expectations for inflation will rise in 2011. Periods of massive easing (code for printing boatloads of money) tend to be very inflationary. The Fed can temporarily keep rates down by purchasing bonds like crazy, but it cannot do so forever. As bond returns begin to languish, money will flow from bonds to stocks, which tend to be more resilient in times of inflation. A relatively benign increase in investor appetite for stocks can make a surprisingly significant difference in stock prices.

China will continue to be the growth engine of the world. During the crisis of 2008, in a period of increasing uncertainty, investors shunned riskier assets like Chinese equities, even though growth continued more or less unabated. When fear subsides, investors return to stocks with strong growth potential. We believe that China, as well as other emerging economies with growth rates higher than the US, will command an increasing percentage of institutional portfolio allocations.

Buy China on the Dips
While it is hard to predict the flux and flow of funds that can determine stock prices in the short run, we are confident that Asia is the long-term investment story of our lifetime. Any short-term dip attributable to tighter monetary policy is likely to offer attractive purchase opportunities for patient, long-term China bulls.

As with all forecasts, we offer a caveat. Debt-laden governments will one day need to reconcile the claims of the bondholders with revenues from their taxpayers. Inevitably, this austerity process will come to a head at some point and curtail growth opportunities when it does. Still, given the vulnerability of the economy, we believe that national and municipal leaders will kick the can in 2011 and that a serious day of reckoning will be pushed out.

In sum, 2011 will be a banner year for small growth stock investors. Indeed, we expect a good year for equity investors broadly. Look for another year of returns north of 10% for the Standard and Poor’s 500 index. Small-cap growth stocks will trump the S&P 500 once again. Growth stocks will experience multiple expansion and we expect the Russell 2000 Growth Index to return more than 15% in 2011.

Despite all the bearish recent headlines associated with China’s tighter monetary policy, we believe that growth rates in China will remain quite strong. As measured by the MSCI China Index and S&P 500, China will beat the US in 2011. Riskier equities fall fast in a downturn, but often burst through the seams when sentiment improves.

[Richard Lehmann recently suggested two low-cost small-cap ETFs with a great recent track record. The hottest mutual fund in Daniel Wiener’s book invests in small caps as well. Last month, Oberweis shared his top 2011 picks, among them a maker of microprocessors that’s rallied 18% since Dec. 28—Editor.] 

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