Several managers believe next year will be better than this year.

Small-cap stocks have led the way out of the recession that ended in 2002. But as the summer started, many small-stock fund managers are opting to keep their powder dry.

  
The managers are optimistic. But they are also realistic. They say that the 43% gain in the average small-stock fund in 2003 is a tough act to follow. For now, their best bet is to buy attractive stocks on price declines. Next year, they expect to profit as the economy hits its stride.

Vincent Gallagher, manager of one small-cap growth fund, the Needham Growth Fund, says current technical and fundamental trends favor larger companies. He is positive on economic growth and is convinced the recent upswing in job creation is a signal the economy could grow to 3% to 4%.

"Since the beginning of the year there has been renewed interest in large-cap stocks," says Gallagher, who also manages Needham's large-cap growth fund. "It is not a rotation out of small caps. But large caps have not had a play for a year and are overdue."

David Bagby, manager of the UMB Scout Small Cap Fund, agrees. He only invests in cash-rich small companies when the technical trends indicate higher stock prices. Now, he isn't buying or selling. "From a valuation perspective large caps are more undervalued," he says. "The cheapest part of the Russell 2000 is the small-cap growth stocks. But the small-stock market is flat."

Bagby expects the stock market to pick up steam as we near the election. Historically, the stock market has performed well in the last half of the fourth year of the decade in which there is a presidential election. He says small-cap growth stocks will gain ground with large-cap growth stocks.

Gallagher believes that large companies will better withstand higher inflation than small companies. In a growing economy, he says, large companies find their better inventory and pricing systems allow them to pass on price increases faster.

Meanwhile, Jean-Pierre Conreur, manager of the Tocqueville Small-Cap Value Fund, isn't buying many stocks this year either. He took some hefty profits after a 66% gain in 2003. Earlier this year, he put the money to work in several distressed manufacturing, consumer and wireless companies. These companies should perform well as the economy improves next year.

"I've not been overly active buying stocks in the last six months," he says. "I am down to 34 stocks from 41 stocks a year ago. I have put some money into companies and reconcentrated the portfolio into existing names."

His largest holdings include Visteon, a plastic auto parts manufacturer; Magnetek, an industrial equipment maker; Del Monte Foods; and Timken, a roller bearing manufacturer.

Small-company stocks have had a strong run since the market crashed in 1999. Over the past four years through June, they have grown at a 10.3% annual rate on average, according to Morningstar Inc., of Chicago. Most of that gain, however, was due to the average 43% gain in small-stock funds in 2003. Small value stocks were the top performers, followed by small blend and small growth.

The performance of small stocks over the past three years is in line with historical data. Data from Ibbotson Associates of Chicago show that since 1954, in the 12 months just following a recession, small-company stocks have outperformed large-company stocks.

A study by Lipper Inc., a New York-based mutual fund analytical firm, found that over the four years ending in the first quarter of 2004, small-cap stock funds outperformed large-cap stock funds. In addition, small-cap stocks were less risky on the downside than were large-cap stocks.

Small-cap funds, particularly funds invested in technology, industrial services and finance companies, registered strong rebounds following the 2000 recession. The rally in small-company stocks was so strong that small-cap electronic technology stocks outperformed large-cap electronic stocks 75% of the time on a weekly, monthly and quarterly basis. And small-cap industrial services funds outperformed their large-cap cousins 87% of the time, according to Lipper.

Over the longer term, however, Lipper data found that large-cap funds outperformed small-cap funds from 1994 through the first quarter of 2004. The growth-stock-driven bull market of the 1990s favored large-company stocks.

Historically, Ibbotson data show that small stocks have outperformed the S&P 500 by two percentage points in total return annually since 1926. However small-company stocks were 60% more volatile.

Ibbotson data also show small-company stocks exhibit a pattern of leading and lagging the S&P 500 for several years at a time. For example, they outpaced the S&P 500 from 1961 through 1968, and then fell behind for eight years. Small-company stocks beat the broad market from 1974 through 1983, while large-company stocks outpaced their smaller cousins for the next seven years. From 1991 through 1993 small stocks outperformed, and underperformed for the next seven years. But from 2000 through 2003, small stocks were the leaders of the pack.

Scott Brayman, manager of the Sentinel Small Company Fund, says quality small-company stocks should dominate the market. In the first half of this year small-cap stocks are tracking the broad market.

"Last year was one of unprecedented stimulus that saw the most dramatic low-quality, high-beta rally I have seen in my career," he says. "Today we have become more discriminating about business risk."

Brayman isn't bullish on small stocks. The reasons: The government's fiscal and monetary stimuli are waning, companies and consumers have high levels of adjustable rate debt and both groups should be hurt by rising rates.

Plus, consumers have been living off the extraction of equity from their mortgages. Those days may soon be history. "I am expecting a transition to quality and narrow breath in the small-cap stocks and large-cap stock leadership," he adds.

Brayman says he has taken profits in technology, retail and restaurants. He's put the money to work in the health care, industrial and consumer sectors. He's buying companies that have good business and are selling at a discount to fair value; his average holding is growing earnings at 15% and has strong cash flows. That has put him into energy companies such as Superior Energy Services, and Clarcor. Health care stocks, which are among his largest holdings, include Arthrocare Corp., Immucore and Biosite. On the real estate side, he likes Costar Group, a provider of online real estate data.

Gallagher, of Needham Small Cap Growth, isn't betting the ranch on small-company stocks either. He says if his fund gained 10% to 15%, he would consider it a good year.

Gallagher typically sticks with technology, health care, business services and consumer specialty stocks, when he can buy them at reasonable prices to their growth rates. To be on the safe side, he has 10% in cash. Another 10% of the portfolio is short on stocks.

"We are still in a stock pickers' market," he says. "We are cautiously optimistic about the second half of the year. We are positive on the economy. We think the rise in interest rates is a nonevent. The market will perform better after the government transition in Iraq and the election is over."

Stocks he favors include Conmed, which makes hospital instruments. Earnings are growing at more than 20%, while the stock is selling at 18 times earnings. In business services, he has a large stake in Iron Mountain. The company's paper and digital storage business is booming. Earnings are growing at more than 15% annually.

He also likes Harris Corp. The company sells electronic equipment to the military and commercial businesses. The stock isn't cheap, but earnings are growing at 20%.

Meanwhile, Bagby of UMB Scout Small Cap Fund is holding stocks that are generating cash flow. These companies are using the money to buy back shares, or to pump money back into the company to boost earnings. That's put him into companies like Helen of Troy, a hair dryer manufacturer; BHA Group, which makes pollution control equipment; and Kansas City Southern, the only railroad that provides service to the United States, Canada and Mexico.

Nevertheless, he says that if his trend-following indicators produced sell signals based on moving averages and relative strength, he would unload his position. The reason: Small-company stock is thinly traded and volatile.

Other managers also are keeping their powder dry. Eric Ende, manager of FPA Perennial, sits on a pile of cash. He has 20% of his fund's assets in cash. "Valuations are not attractive," he says. "We look at return of capital, equity and assets. We want to buy profitable business at undervalued prices. We are nibbling at stocks and spending cash that is coming into the fund."

Ende typically concentrates the fund in about 30 to 40 names. He likes to buy cheap and hold them for a few years. Some of his largest holdings include ScanDisk, which makes memory cards for digital cameras; Health Management Association, which runs for-profit hospitals in rural areas; and Oshkosh, a specialty truck manufacturer that is doing big business with the military.