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Small-Cap Stocks Surge Ahead of the Big Names

In a Wall Street universe populated by marquee name stocks, the lesser known entities are the stars of the rally so far this year.

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The Russell 2000 index , which tracks stocks with a small market capitalization, is nearing its record highwith a rise of about 11 percent in the year to date. That outstrips the Russell 1000 index that measures Wall Street’s large capitalization stocks and the Standard & Poor’s 500-stock index that measures the broader market.

The surge in the so-called small-cap stocks — companies whose total share value is $3 billion or less — indicates that investors’ appetite for risk is growing as signs of recovery persist in the United States and euro zone leaders make progress in containing the debt crisis, market participants say.

After investors drained more than $15 billion out of small-cap stocks last year, the largest amount since 2007, they have sunk about $2.4 billion back into those equities so far this year, according to data provided by Lipper, a Thomson Reuters company.

“It is a decent confidence barometer,” said Scott Wren, a senior equity strategist for Wells Fargo Advisors. “Investors are confident enough to buy some of these small companies, betting that the U.S. economy is going to continue to grow.”

Most of that money poured into the small-cap stocks in the seven days that ended February 8, the last tally by Lipper. During that time, the Labor Department reported a gain of 243,000 jobs in January and the lowest unemployment rate since early 2009, while another report, from the Institute for Supply Management, showed that economic activity in the nonmanufacturing sector grew in January for the 25th consecutive month.

Tom Roseen, a senior analyst at Lipper, said there was a similar inflow into small caps in the beginning of 2011, but this year’s inflows were notable because they were a turnaround from a full year in which investors focused on dividend-paying and large-capitalization stocks.

But analysts were also cautious in ascribing too much staying power in the risk trade. Volatility could return to equities because of the entrenched euro zone debt problems, the potential for a recession in Europe and concerns about economic growth in the United States.

Steven G. DeSanctis, a small-cap strategist with Bank of America Merrill Lynch, noted that a lot of the inflows so far this year were by exchange-traded funds, which are highly liquid, and thus could just as easily flow out.

Pharmaceuticals, materials and technology companies are showing particularly robust returns among small caps so far this year. Inhibitex , FriendFinder Networks and Georgia Gulf are among the best small-cap performers in terms of returns, according to data tracked by the Russell index.

The stock price of Inhibitex, a biopharmaceutical company, is up more than 130 percent, mostly because it was acquired. Georgia Gulf, which makes chemical and plastic products, is up 74 percent, and FriendFinder, an Internet networking company, is up more than 200 percent.

The rebound in small-cap stocks is a sign for some analysts of a broader recovery in the financial markets. In the second half of last year, the markets were buffeted by a period of volatility from the European crisis and the credit rating downgradeof long-term United States debt, contributing to a fall in the Russell 2000 for the year of about 4 percent.

But so far this year, the broader market as measured by the Standard & Poor’s 500 has had its best start since 1987. As of Monday it was up 7.5 percent for the year to date. Small-cap companies are not traded as frequently, and therefore their stock prices can be choppy. And there are fewer analysts researching these companies for investors, unlike with big names like Apple. They also are more likely to be the object of takeovers, like Inhibitex, which Bristol-Myers Squibb said in January it would acquire for $2.5 billion.

Mergers and acquisitions, which are expected to push ahead as companies come off a period of hoarding cash, usually involve small-cap companies.

“This year we are expecting an acceleration of M.& A. activity,” said Christopher J. Colarik, small-cap portfolio manager for Glenmede Investment Management. “Larger companies look for growth, and there are a lot of clean balance sheets.”

This was especially true in the pharmaceutical field, said Jon Eggins, portfolio manager at Russell Investments.

Since 2008, drug companies have been cautious about large investments in new research, but they are also faced with the expirations of profitable drug patents and looking for ways to bridge the potential shortfall in earnings, he said in an e-mail reply to questions.

And their revenue is mostly generated inside the United States, which means they are less influenced by turmoil in Europe.

“They are more of a niche market, and they may have a lot of room to expand geographically and internationally,” Mr. Wren said. “Their earnings growth rates are far in excess of what a large company might be.”

In the last 10 years, the Russell 2000 index has returned 5.6 percent, compared with 3.3 percent for the Russell 1000. “That added return premium hasn’t been for free, though, as there has been higher risk associated with this return,” Mr. Eggins said.

Mr. DeSanctis, the strategist with Bank of America Merrill Lynch, said his firm’s forecasts included an 11 percent return for small-cap stocks in 2012, in line with the historical annualized average.

“We have already achieved that in the first six weeks of the year,” he said.