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Analysis: Smaller caps seen doing better this earnings season

By Caroline Valetkevitch and Chuck Mikolajczak

NEW YORK (Reuters) - Perhaps familiarity does breed contempt. The biggest U.S. companies have often failed to meet forecasts this earnings season, while their smaller counterparts have delivered.

"Big-cap" companies have been hit with a number of high-profile earnings disappointments, including most recently, Hewlett-Packard and Dell . The percent of companies exceeding expectations is the lowest since the end of 2008 and profit margins are deteriorating.

"Small-caps", meanwhile, are beating estimates at a rate comparable to recent quarters, and profit margins are on the rise. It's a sign that U.S. economic recovery continues to gain momentum as domestic rather than export growth helps the smaller names. Companies in the technology and industrial sectors have a bigger representation in the smaller capitalization indexes.

Investors have noticed. Performance in both the Standard & Poor's mid-cap and small-cap indexes is outpacing the benchmark S&P 500 in 2012.

"The reason they are performing well is because they are earning it. They are simply growing faster," said Lawrence Creatura, portfolio manager at Federated Clover Investment Advisors in Rochester, New York.

The U.S. economy has been growing steadily and is expected to outpace growth in Europe in coming years. A January 19 Reuters economists' poll shows expected global growth will slow to around 3.3 percent this year from an estimated 3.7 percent in 2011.

U.S. growth was seen averaging 2.2 percent in 2012, up a December forecast for 2.1 percent, but U.S. data has improved since then.

A look at the beat rate for the three indexes shows a similar number of companies exceeding results. It's at 60 percent for the S&P 600 <.SML> index and at 61.5 percent for S&P 400 mid-cap <.MID> earnings, slightly below the beat rate of 63.9 percent for the Standard & Poor's 500 <.SPX>, according to Thomson Reuters and Brown Brothers Harriman data.

What's notable, though, is that the smaller companies are in line with previous quarters. In the third quarter, the S&P 400 saw a beat rate of 63.7 percent and the S&P 600 saw a beat rate of 59.2 percent. The S&P 500 is falling far short of its average of 70 percent for the past four quarters, BBH and Thomson Reuters data showed.

The trend goes against what investors are used to seeing. Companies with a large market capitalization typically have a better track record for exceeding analyst expectations, partly because smaller companies are less predictable and the fewer number of analysts covering the company means estimates vary more widely.

Earnings for smaller-caps reflect stronger growth trends so far. Earnings growth for the small-cap S&P 600 is expected to rise 12.1 percent in first quarter, similar to growth so far for the fourth quarter, BBH analyst Charles Blood said.

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By comparison, earnings growth for companies in the S&P500 index is estimated to fall to about 2.1 percent for the first quarter from estimated growth of about 9.0 percent for the fourth quarter of last year. Take out Apple , and S&P 500 first-quarter profit growth is expected to be about 1.0 percent.

Concerns abound among those who see recent economic strength as fleeting, however. Bank of America-Merrill Lynch small cap strategist Steven DeSanctis expects estimates to decline.

"If the economy is going to slow as rapidly as we think...I think you're going to get some cuts in estimates, and if you don't get cuts in estimates, you're going to have more companies reporting negative surprises," DeSanctis said.

MARGIN IMPROVEMENT, BETTER GROWTH

The mid-cap index is up 12.5 percent this year and the small-caps have gained 11.2 percent, while the S&P 500 is up 8.8 percent.

Operating margins are declining for the large-cap names, while they are holding or rising for smaller caps. Investors for some time have been expecting cost cutting to grow more difficult for big companies, limiting their ability to beat profit estimates. The slimmer margins and reduced number of companies coming out ahead of estimates shows this is the case now.

Fourth-quarter operating margins were at 8.8 percent for the S&P 500, down from 9.5 percent in the third quarter. Smaller companies have thinner margins but those margins are rising. The fourth-quarter level was at 5.0 percent for the S&P 600, an increase from 4.2 percent in the third, according to S&P index analyst Howard Silverblatt.

Overall revenue growth is stronger as well. Thomson Reuters Starmine data shows year-over-year revenue growth of 11.7 percent for the small-cap 600 index and 12.4 percent for the mid-cap 400 compared with 10.6 percent growth for the S&P 500.

The smaller indexes are more growth-oriented, and as the economy improves it has an outsized benefit on smaller stocks.

"Small-cap indices... (have) a higher percentage of businesses in the economically sensitive sectors," said Lance James, micro-cap/small-cap portfolio manager at RBC Global Asset Management in Boston.

Taking the S&P Small-Cap and Mid-Cap sectors together, the financials, technology, industrials and consumer discretionary stocks account for 71 percent of the issues - compared with 59 percent of the S&P 500.

"More manufacturing is going to be done here in the U.S. That is a trend that can continue and is not just a one-year anomaly," said James.

(Reporting by Caroline Valetkevitch and Chuck Mikolajczak)

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