Monday, Sep. 21, 1998

Don't Buy The S&P

By James J. Cramer

In the trenches we call them the generals. They are the big-dollar stocks, the companies that make up the Standard & Poors 500. Most of the Generals go up year after year, and they buy back lots of their shares. We stock pickers hate them--and with good reason. A machine, buying shares of the S&P 500, has beaten the vast majority of stock pickers--including 77% of those who ran mutual funds over the past five years. It makes us all look bad.

Most professional investors, including me, scorned index funds for years. I used to think, heck, if I just picked the 400 best of the 500, I could do better. It hasn't played out that way. Any investor who sought value among smaller stocks has seen his returns lag badly. The Russell 2000, an index of small-cap stocks, has fallen about 20% so far this year, and trailed the S&P 500 nearly 11 percentage points in 1997.

Yet lately the Generals have come under attack for being too richly priced relative to their earnings and other benchmarks of value. And they got that way, in large part, precisely because they belong to the most popular index and simply got floated higher and higher on a tide of investor cash. Just this week Procter & Gamble, a charter member of the S&P 500, announced that it could not meet its growth targets. Coca-Cola too has stumbled on slower overseas growth. And the computerized "sell programs" have made the Generals ride a roller coaster of late.

To be sure, there will be plenty of action among the big guys in the near future. Too much money is still pouring in over the transom. And with Intel preannouncing better revenues last week, the personal-computer sector, dominated by S&P companies, is turning red hot.

Nevertheless, the disparity in price has simply grown too wide between big and small companies with comparable earnings per share and comparable prospects going forward. Last week the great Peter Lynch--who outperformed the S&P for the 13 years during which he made Fidelity's Magellan Fund America's largest--brought his common-sense wisdom to bear on the issue. He's adamant that the real value today is in the little stocks, and he's confident that some will grow to be big ones. You have to get the next Ciscos and Intels precisely when they are not hot if you are ever going to get rich at this game.

I hear Lynch loud and clear, and have made a study of what value looks like: cyclical stocks trading at only 7.5 times their expected 1999 earnings; institutions like Staten Island Bank and Webster Financial of Connecticut selling near book value; broken initial public offerings (like Keebler, or Waddell and Reed Financial), which have exciting prospects a year or two out.

They probably won't pay off immediately, but small stocks will reward the patient, as they always have before when they were this much cheaper than the large caps. If you don't have time to research individual companies, consider a solid small-cap fund like Babson Enterprise II or Berger Small Cap Value, or a Russell 2000 index fund, which gathers the small-cap castoffs in a neat bundle. Or buy a fund based on the Wilshire 5000 index, which includes both large- and small-cap stocks. Both types are sold by fund companies like Vanguard and Fidelity. But do me a favor, and do one for yourself: don't buy the S&P.

Cramer writes for the street.com and manages a hedge fund. He holds investments in Cisco and Intel. Nothing in this column should be construed as advice to buy or sell stocks.