Why the small-cap rally may stall

NEW YORK (Reuters) - One of the riskier segments of the stock market just had its best August performance since 2008, leading some investors to question whether it was all just a summer fluke.

The Russell 2000 index of small and mid-cap stocks jumped 3.2 percent last month, compared with a nearly 2 percent gain in the Standard & Poor's 500 index of large cap stocks. The index was pushed higher by gains such as a 115 percent return for Sunrise Senior Living Inc and a 92 percent gain for Kenexa Corp, both of which came after the companies agreed to be acquired by larger rivals.

Before the jump, the Russell had underperformed the S&P 500 by about 3 percentage points for the year. Now, the two indexes are roughly even.

Yet some strategists and analysts caution it may be too soon to jump onto the small-cap rally, even with the European Central Bank's announcement on Thursday that it would expand efforts to contain the region's debt crisis.

These small companies, such as metals-distributor A.M. Castle & Co, tend to have market capitalizations between roughly $300 million and $2 billion and are inherently riskier than larger companies. They tend to be more dependent on banks for financing, have fewer products and often depend on the U.S. economy alone for profits, analysts noted. As a result, the annual performance of the Russell 2000 index is often several percentage points above or below the more stable S&P 500.

"As risk comes back into the market - which it certainly will - you will see a pullback. The performance of small and mid-caps is almost a referendum on whether the market thinks that growth remains stable," said Quincy Krosby, a market strategist at Prudential Financial.

Roadblocks ranging from Europe's unfolding debt problems to the outcome of the U.S. elections will likely squash any meaningful gains for small-caps over the next two months, analysts said. But that span could also benefit investors who focus on stock selection over broad bets on the category.

Here are suggestions on how to make the most of a small-cap slowdown.

WAIT UNTIL AFTER THE ELECTION

Uncertainty over the outcome of U.S. election that will determine which party is in control of the presidency and each branch of Congress should cap the sector's gains until November, analysts said. That is because small-cap companies are the most sensitive to policy changes that affect the U.S. economy.

Brain Peery, a portfolio manager at Hennessy Funds who runs large, mid and small-cap funds, expects that most fund managers and institutional investors have "settled in" their positions until the outcome of the election is clear.

"Any further rebound in small caps will depend on how much risk comes off the table in terms of the economy, of potential tax consequences and whether there's some clarity with this looming fiscal cliff," he said.

He is maintaining but not adding to his positions in small cap stocks because he believes investors will start chasing performance after the election, especially if the S&P 500 pulls ahead by a few percentage points. That would be the time to once again buy into the sector, he said.

One of his top holdings is $720 million market cap Leapfrog Enterprises Inc, a Bay Area company that makes educational toys and tablets for children. The company is up nearly 92 percent for the year and trades at a price to earnings ratio of 17.4.

Bob Auer, fund manager of the $71.5 million Auer Growth fund, said that a general lack of dividends and a dearth of investor excitement for the category would likely prevent any meaningful gains, at least in the short-term. Some of these companies are too small for many institutional investors to hold. That should make for a better environment for stock-picking, he added.

He is buying small-cap companies that meet certain criteria such as making 20 percent sales gains in their most recent quarters and trading at a price to earnings ratio below 12. One of his top holdings is $423 million market-cap MYR Group Inc, a Rolling Meadows, Illinois, specialty contractor that builds and repairs power lines. The company's shares are up nearly 8 percent for the year through Wednesday's close and its current quarter earnings per share are expected to grow by 119 percent compared with the same time last year, according to Thomson Reuters data.

LOOKING FOR BETTER VALUE

Other analysts suggest that small caps are already fairly valued, giving little obvious reason for a broad bet on the sector.

Gene Goldman, the head of research at Los Angeles-based Cetera Financial Group, said large caps remain a better value than small caps. Large caps are trading at about 75 percent of their price to earnings valuation over the last 20 years, while small caps are trading at 84 percent of their own history.

"The cheapness just isn't there," he added.

Marvin Williams, a financial adviser at Exencial Wealth Advisors in Oklahoma City, Oklahoma, said there are better values in international small cap value stocks. These stocks currently trade at an average of 60 percent of their book value. Large cap international value stocks, meanwhile, trade at about 82 percent of their book value, he said.

Williams is making broad bets on the sector using entities such as the $7.8 billion DFA International Small Cap Fund.

"When you're at 60 cents on the dollar, you would be wise to just stay very diversified and insure that you are going to get that premium," he said. "Once you start taking on additional risks, like country risks or individual stock selection risk, you aren't assured that you'll get that out-performance."

The DFA fund is up 7.1 percent for the year and charges 70 cents per $100 invested. Its largest holdings include Travis Perkins Plc, Hiscox Ltd and Persimmon Plc.

(Reporting By David Randall; Editing by Walden Siew and Andre Grenon)