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Is the party over for small caps?

March 28, 2014: 10:43 AM ET

Small caps may be losing some sizzle, but that doesn't necessarily mean investors should bail on the asset class all together.

After outperforming the broader market for the past 12 months, the Russell 2000 Index, the most popular broad index of small caps, has pulled back in recent days. While it's been a choppy week overall, the Russell 2000 is down more than the major US markets like the S&P 500 and the Nasdaq.

With a median value of $740 million, stocks in the Russell 2000 have been dragged down by drops in risky but booming stocks in biotechnology and social media. As the valuations of these small companies have soared, some are beginning to wonder if there's too much speculation of future growth and profits that won't materialize.

The iShares Nasdaq Biotechnology ETF, for example, has plummeted over 9% since last week after surging over 20% earlier in the year.

Marc Roberts, who helps manage $1.9 billion for Fenimore Asset Management, loves small caps, but is wary of the Russell 2000 index. He said that the index trades at a lofty 25 times earnings and that 17% of its companies had negative earnings last year. Among them are many hot biotechnology firms that so far haven't turned a profit and are dependent on not-yet-approved drugs.

"Profitable companies have become a smaller part of the index," he said.

And it's not just biotech. One of the most well known small caps is Yelp (Yelp), the restaurant and consumer business review site. It has tanked around 6% this week, even though it's up 230% in the past year.

Yelp, a member of the Russell 2000, has fallen in recent days but is still up big.

Small companies are often seen as an indicator of where the market  -- and the broader economy -- is headed. These "little guys" tend to be the first to feel the effects of swings in everything from labor and material costs to interest rate moves.

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Still, many advisors recommend owning small caps as part of a healthy diversification strategy. And that's why investing in this type of asset class may mean checking conventional investing wisdom at the door.

Whereas purchasing a low cost index fund that tracks the S&P 500 is a widely recommended tactic, buying an index fund tied to the Russell 2000 necessitates more comfort with market swings. It could leave investors saddled with risky stocks, Roberts said.

That's why he argues for old school stock picking when it comes to small caps. There are still great plays, but investors have to be selective. He likes some of the regional banks and real estate investment trusts in the Russell 2000. "In some of these small names there's an opportunity to dig deeper and find hidden gems that the broader market isn't doing much work on," he said.

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But Seth Reicher of $2.2 billion Snyder Capital Management in San Francisco doesn't think small caps are overheating. He argues that once negative earnings are stripped out, the Russell 2000 is trading at 19 times earnings. That's still a bit lofty, but only slightly above the roughly 15.5 for the S&P 500.

Another issue with small caps is the Fed's winding down of the stimulus. It's not a coincidence that small caps have suffered since Janet Yellen's comments last week. That's because a lot of small firms took advantage of the Fed's easy money and low rate policies to borrow heavily. Such examples include energy companies, which Reich said make up 5-6% of the Russell 2000. He said the energy sector took on debt in recent years to fund exploration, which may or may not have born fruit.

REITS, real estate investments, could also be sensitive to rising rates because they rely on obtaining mortgages to make acquisitions. But conversely, small cap regional banks and insurance companies could get better returns if they're lending money at higher rates.

As for high-flying biotechnology small caps, Reicher feels they're too unpredictable, so he's steering clear. "You're buying them on a little bit of a hope and a prayer," he said. "People are renting the stocks, not owning them."

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