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A Free Lunch in the Stock Market

May 11, 1993

NEW YORK (AP) _ When stocks are discussed, the person with a portfolio of blue chips, the kind favored by institutions and brokers, is usually considered an astute investor.

In contrast, the portfolio filled with the very smallest stocks, those with equity of less than $100 million - sometimes only a fraction of that figure - is viewed with skepticism, and its owner may be deemed an amateur.

Rarely do impression and reality conflict so sharply.

Extensive research shows that over an extended period, the well-chosen portfolio of smaller stocks is likely to outperform that portfolio of larger stocks, and by a considerable and financially significant margin.

One study, by Ibbotson Associates of Chicago, traced 67 years of returns for the smallest and largest 20 percent of New York Stock Exchange listings. Results: The small returned 19.6 percent annually; the large, 11.6 percent.

Even when adjusted for the added risk, smaller stocks still outscore the larger ones over periods of several years. If such stocks are held rather than traded, they might even double the return of large-stock holdings.

While studies of even smaller stocks show such consistent results it is hard to deny the existence of the small-company effect, about 15 years after its discovery it is all but ignored by many investors.

Why? Big institutions cannot effectively enter the small-stock arena, simply because there aren’t enough shares available. To a great extent, therefore, large brokers do not even follow or analyze such stocks.

Because of this and some lesser factors, the supply of news and information about such shares is limited, allowing for inefficiencies in pricing. Often, the inefficiency is reflected in a bargain price, which become future gains.

For the patient investor - small stocks have streaks, measured in years, of superior and inferior results - the results can be astounding, a free lunch in a marketplace that generally offers nothing without a fight.

Other factors contribute, none more than the entrepreneurial spirit and management responsibility that often exists in smaller companies. Managers usually own a large percentage of the stock, and they work hard to protect it.

Eventually, many good small companies become large enough to attract the attention of professionals, and have a large enough volume of shares outstanding to accommodate the big-block purchases of institutions.

As growth continues, they leave the small-company category and enter the larger world. No longer are they ignored by the media. No longer are they as inefficiently priced. Early, patient investors obtain their reward.

Gerald Perritt, a former mathematics professor, has been perhaps the sharpest analyst of the small-stock effect over the past 10 years, mainly through his Chicago-based market letter, ″Investment Horizons.″

Based on his experience and analysis, management of a small-stock portfolio requires adherence to three basic rules, the first of which is diversification.

Without an undiversified portfolio, he says, ″small-firm stock investors are subject to the luck of the draw.″

His research shows it takes at least 20 small stocks to achieve the same diversification benefit, or protection, as a portfolio of 10 to 15 large- company stocks.

Second, ″we have maintained our commitment to small-firm stocks through thick and thin.″ This can be difficult to do, because of the tendency of smaller stocks to go through long periods of under- and over-performance.

The cycle turned in favor of smaller company stocks in late 1990. During 1991, they returned about 44 percent, versus 30.5 percent for the Standard & Poor’s 500-stock index. Last year they topped the market at 16.4 percent.

Third on Perritt’s list of musts is patience. Low portfolio turnover not only can greatly cut transaction costs, but it affords the small companies an opportunity to meet their return potential.

In addition to the three basic rules, Perritt offers a this bit of advice: Avoid the temptation to fall in love with the better-performing small-company stocks. When a company becomes mid-size, he sells it.

End Adv PMs Tuesday, May 11

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