3 Small-Cap Stocks the Pros Like

When the market is struggling, investors favor size and stability. So it's curious that small companies are currently faring better than their larger brethren. Large caps trumped small caps in 2007, but so far this year, smaller stocks are in the lead: The small-company Russell 2000, which has bounced back 10 percent from its mid-March low, is down 7 percent so far in 2008, versus 14 percent for the S&P 500 stock index. "This is a little surprising, given that small companies have had a six-to-seven-year run of outperformance. It doesn't usually work that way," says Sam Dedio, manager of the Julius Baer U.S. Smallcap fund. "Given what's happening with the economy, it's a tough call: Either this is a mild downturn and small caps are leading us out or this is a double-dip recession."

In down markets, smaller names tend to take a beating as investors flock to less risky companies. However, history shows that small caps are also the first to bounce back when the economy is heading out of a recessionary period. "It's still too early to declare victory," says Matthew Ziehl, manager of the RS Small Cap Core Equity fund. "Small-cap performance looks reasonably competitive on a 12-to-18-month horizon, but it's way too early to look to an economic recovery."

Regardless of what the economy is doing, there's a case for reserving a slice of your portfolio for the little guys. Over long periods, small-company stocks tend to lead those of large companies: Since 1926, small caps have returned an average of 12.5 percent per year, compared with 10.4 percent for large caps, according to Morningstar. But their performance in the short term can be wildly volatile. It may be a little early to be jumping into small-cap stocks with both feet, but investors willing to take on some risk might consider the following picks:

Cheesecake Factory (CAKE). Rising food and fuel costs mean tough times for the restaurant industry. The Cheesecake Factory is no exception: Its stock, at $15, is down from $25 a year ago. But Dedio sees plenty of sales growth ahead, fueled by new restaurant openings. (The company, which has more than 140 locations, opened 21 new restaurants in both 2006 and 2007.) "If you look at Cheesecake Factory's history, it opens new restaurants with internal cash flow, meaning it internally funds its growing business rather than going out and issuing more company stock," he says. Shares of the $1 billion company currently trade at 14 times analysts' 2008 earnings estimates of $1.04 per share.

Cubist Pharmaceuticals (CBST). Fast-growing companies selling cheaply are the focus of the Auer Growth fund, which considers firms of any size for its $88 million portfolio. Among small companies, manager Bob Auer favors Cubist, a stock that has "performed well in a sloppy market," he says. (So far this year, shares have gained 9 percent.) The Lexington, Mass., company's flagship product—Cubicin, an antibiotic that treats a bacterial skin infection called MRSA—enjoys patent protection until 2019. The $1.3 billion company, which reported sales of $250 million in 2007, recently raised its 2008 revenue guidance to between $395 million and $405 million, and expects to eventually ramp up to $750 million. Cubist's shares, recently $22, trade at 21 times the $1.06 per share analysts expect it to earn in 2008 and 13 times the $1.66 a share expected for 2009.

Sequenom (SQNM). If you're concerned about the economy, healthcare is a good place to be, says Ziehl, because the industry tends to hold up in down markets. He likes Sequenom, a $934 million diagnostics firm that's close to commercializing a new, noninvasive screening test for Down syndrome. This development-stage company "still has negative earnings and is in cash-burn mode, so it doesn't have a fortress-type balance sheet," says Ziehl. "However, they recently did a $90 million share offering, so they have plenty of money to get to the other side." Sequenom is currently entering a Phase 3 clinical trial, which it expects to complete early next year. The company's stock recently traded at $20 and has doubled since the beginning of 2008.