Inflation Could Aid Small Firms

Wall Street’s fear of an inflation surge from higher oil prices is one major element in the stock market’s broad decline. But some investors see a silver lining: If history repeats, rising inflation might help small stocks finally begin to outperform big stocks.

In the late 1970s, the last period of rampant inflation from higher oil prices and other factors, stocks of small companies were the market’s stars. From 1976 to 1979, as the consumer price index leaped from a 4.8% annual rate to a 13.3% rate, the NASDAQ over-the-counter composite stock index dramatically outperformed the blue chip Standard & Poor’s 500 index, as the chart shows.

In contrast, for most of the low-inflation 1980s, small stocks badly lagged the blue chips. Last year, for example, the OTC index rose 19.3% while the S&P; rocketed 27.3%.

Why would inflation be good for small firms, and thus their stocks? There are a lot of theories:

* Small companies “can respond quicker to changes in the economy,� says Charles Royce, who runs the Pennsylvania Mutual fund, one of the nation’s premier small-stock funds. Thus, small companies’ earnings gains may become more noticeable in a troubled high-inflation period, when bigger companies are struggling to react to new realities. “Small companies’ individual progress tends to stick out more,� Royce says, and that attracts investors.

* Ronald Sloan, chief investment officer at Siebel Capital Management in Larkspur, Calif., says higher inflation allows big companies to cover more mistakes and inefficiencies with price increases. “They get sloppier, and that means more opportunities for small companies� to exploit market niches or compete on price, he says.

* The higher inflation goes, the higher the return that investors seek in the stock market and on other investments, notes Fred Applegate of Nicholas-Applegate Capital Management in San Diego. So small companies that deliver strong growth see their stocks bid up as inflation rises, because investors are willing to pay a greater premium for the stocks, he says.

It all sounds reasonable. But in truth, even small stocks’ strongest proponents admit they can’t prove their theories. “I’m not certain you can apply them across the board,� Royce says.

Some experts worry that small-stock fans are just desperate for any ray of hope, given the abysmal record of the stocks in the 1980s.

Claudia Mott, small-stock analyst at Prudential-Bache Securities in New York, says the group’s stellar results in the late ‘70s may have been a function of the businesses most heavily represented in small-stock indexes--service companies and technology, for example. Those companies weren’t as hurt by inflation as were the industrial companies in the S&P; 500.

But there’s no guarantee that history will repeat if inflation jumps again, Mott notes. Given big companies’ efforts to slash expenses in the 1980s, they may be far better prepared for high inflation and a tough world economy now than in the late ‘70s, she says.

Although many small-stock proponents have argued for some time that the stocks are bound to retake the lead in the market in the 1990s, Mott says it won’t happen this year. Small stocks would catch more investors’ attention if key small-stock indexes began to outperform the S&P; 500. But Mott notes that bank stocks, heavily represented in the OTC market, are weak and getting weaker. Meanwhile, oil stocks, which are under-represented in the OTC market, are leading the market. That suggests a poor small-stock performance, relative to the S&P; 500, at least for the rest of this year.

Says Mott: “I was pounding the table on small stocks earlier this year, but I’m about ready to throw in the towel now.�

Briefly: Capital Group, the L.A.-based mutual fund and private money management giant, moved up sharply in the annual ranking of America’s 300 largest money managers. The list, in the July issue of Institutional Investor magazine, shows Capital managing $51.78 billion at year-end 1989, up from $38.87 billion a year earlier. That pushed the firm to No. 16 from No. 22 among the top 300 money managers. No. 1 is American Express (which manages $157.17 billion), followed by Prudential Insurance ($156.33 billion) and Bankers Trust Co. ($114.77 billion). . . .

Stock bargain hunters in the Southland know just what they’re looking for right now, says Anthony Chidoni, trading chief at Donaldson, Lukfin & Jenrette in L.A. “They’re buying assets and they’re buying cash,� he says. A few examples, he says, include General Cinema ($19.125 now), which holds $18.75 a share in cash; Tyco Toys ($15.875), which has a nominal book value of $14 a share, and Paramount Communications ($36.375), whose book value is around $30, Chidoni says.

SMALL STOCKS AND INFLATION Do small stocks perform better in a high-inflation environment? Here’s how the NASDAQ over-the-counter stock index performed in the late-1970s and early-1980s, as inflation surged. The big-stock S&P; 500 index’s performance also is shown.

NASDAQ S&P; Inflation Year OTC index 500 (CPI) 1974 -35.1% -29.7% 12.2% 1975 +29.6% +31.5% 7.0% 1976 +26.1% +19.2% 4.8% 1977 +7.3% -11.5% 6.8% 1978 +12.3% +1.6% 9.0% 1979 +28.1% +11.7% 13.3% 1980 +33.9% +25.8% 12.4% 1981 -3.2% -9.7% 8.9% 1982 +18.7% +14.8% 3.9% 1983 +19.9% +17.3% 3.8%