Small firms outpaced by big-caps on earnings

As third quarter earnings season takes off, bigger is better.

With the U.S. economy emerging from recession, large cap stocks are set to have a stronger third-quarter earnings season than their mid and small cap counterparts, which are expected to rebound at a slower pace.

This goes against the usual trend when the economy emerges from recession, analysts say. Often, smaller companies recover more rapidly as the economy expands.

This time, large caps have several factors working in their favor. The weakness of the dollar helps multinationals that export product overseas, and also provides them a favorable currency translation.

Government assistance in the credit markets also drove down borrowing costs for big financials, set to report another quarter of strong profits.

And statistical comparisons with year-ago results will be flattering for large caps devastated in the second half of 2008.

So while mid and small cap firms may prove more flexible if an economic rebound takes hold, their bigger brothers appear better equipped to weather a slow-plod recovery.

Especially in the financials, the small cap space still seems to have its issues in terms of earnings, and so that is going to be a pretty big drag in terms of the profit numbers, said Steve DeSanctis, small-cap strategist at Bank of America Merrill Lynch in New York. You're getting probably more of a recovery in the large-cap earnings.

BIG COMEBACK

Expectations that small and mid cap companies would recover first is apparent in the performance of the shares.

Since hitting 12-year lows on March 9, small and mid cap stocks have led the recovery, with the S&P MidCap 400 index rising 72.4 percent and the S&P SmallCap 600 index jumping 76.5 percent. In comparison, the S&P 500 index .SPX has gained 57.8 percent.

But third and fourth quarter estimates favor the large cap names. According to data from Thomson Reuters, third-quarter earnings for large cap stocks are expected to decline 25.3 percent. By contrast, Bank of America-Merrill Lynch researchers predict a decline of 26.6 percent for midcaps and almost 31 percent for small caps.

The earnings collapse in the second half of 2008 hit large cap names harder than smaller stocks. Mid caps, in particular, have a heavy exposure to the energy and materials sectors, which were stronger in the second half of 2008, Bank of America-Merrill Lynch noted.

The majority of the large cap profit recovery is expected to be provided by financial stocks, as analysts project a 56.9 percent increase in earnings from a year-ago, when profits were crippled by the near-collapse of the banking system.

Smaller financials have also been under pressure for their exposure to commercial real estate, which may hamper their quarterly profits.

With Street numbers for 3Q09 expected to show improvement from awful results the prior three quarters, the bulk of the benefit is less pain in the financials sector on a year-over-year basis, said Citi analyst Tobias Levkovich, in a recent note to clients.

TIDE MAY TURN FOR SMALLER FISH

The dollar's fall will aid companies with overseas operations. The trade-weighted dollar is down about 14 percent from its high in March 2009, according to Citigroup.

Those mid and small cap companies with overseas exposure will benefit. But it's the large-cap S&P 500, where 32 percent of sales come from overseas, that garners the greatest gain, according to Citigroup.

To be sure, some investors think the financial dexterity of smaller companies to adjust to changes in the economic landscape will benefit them more in coming quarters.

In the mid-cap spaces and in the small cap space they cut earlier, and they will actually see growth sooner and they will add back sooner, said John Schonberg, manager of RiverSource Mid Cap Growth Fund in Minneapolis.

Still, should a double dip recession occur, small companies could be caught up in that downdraft, which could reverse some of the gains in those shares since March.

For now, investors anticipate smaller names will continue to lead in share value gains, even if the bottom-line figures look better for their large cap brethren this quarter. (Editing by Andrew Hay)