From the October 2003 issue of Investment Advisor • Subscribe!

October 1, 2003

A Sustainable Small-Cap Revival?

Small-cap growth funds are outperforming the broad market as the economic recovery spurs investor confidence. Like previous rebounds, the current recovery is generating disproportionately higher earnings ratios for small-cap growth stocks. With lower revenue bases than large companies, small companies generally outperform in recoveries as higher sales have a bigger impact on revenues and earnings.

Small-cap growth stocks have also gained this year as investors move into more volatile, higher-beta areas of the market. With the rising economy boosting market sentiment, investors have increasingly shifted from defensive positions to more growth-oriented areas.

Unlike small-cap growth stocks' outsized returns of the 1990s, Standard & Poor's feels this year's market returns are generally sustainable. "We don't see the market getting out of hand--investors have learned not to get overextended," says Sam Stovall, Standard & Poor's chief investment strategist.

The AIM Opportunities I (ASCOX) fund focuses on companies with 15% top-line growth, stable or improving gross margins, and upward earnings revisions. As of August 2003, information technology, consumer discretionary, and health care were the largest sectors. The fund may also hold short positions of up to 25% of assets. Currently, short positions make up just 10% of the fund, a modest weighting that reflects manager Charles Scavone's optimistic market outlook.

The Hennessy Cornerstone Growth Fund (HFCGX) follows a quantitative process to find 50 stocks with price-to-sales ratios of 1.5 or less and the best relative strength for the most recent three-month, six-month, and one-year periods. Manager Neil Hennessy selects the best 50 stocks and rebalances the portfolio yearly. As of August 2003, retail represented 17% of the portfolio, financial services 10%, and services and transportation 10%. Currently, 48% of the fund's holdings are dividend-paying stocks, a sign of attractive valuations there, Hennessy argues.

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