Big gains for small stocks.

When it comes to investing in stocks these days, the small and mercurial David is leaving the blue-chip giant Goliath in the dust. That's why a growing number of investors are buying the stocks of smaller companies that are listed on the over-the-counter (OTC) market, which is currently in the middle of a boom. Although considered riskier than the more capitalized issues traded on the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX), the smaller stocks have made their mark with investors this year.

OTC stocks trade on the NASDAQ (National Association of Security Dealers Automated Quotations) system, the composite index that has gained an astounding 40.9% in the first three quarters of 1991. At the end of last September, the NASDAQ index stood at 526.88. The increase in the NASDAQ composite index doubled the rise of the Dow Jones Industrials, New York Stock Exchange Composite and the Standard & Poor's 500 in the same nine-month period. This is a change from the 1980s, during which the NASDAQ system was outperformed by the S&P 500.

Moreover, by the third quarter of 1991, NASDAQ's share volume amounted to 29.9 billion shares, topping the old mark of 28.3 billion shares in 1987. NASDAQ's dollar volume also set a record, surging to $491 billion for the first three quarters of 1991, eclipsing the previous high of $395 billion set in the same high-flying year of 1987. NASDAQ is likely to perform well for the balance of the year as the economy continues to recover, says Gene Finn, vice president and chief economist for the National Association of Securities Dealers (NASD). Gerald Perritt, Chicago publisher of Investment Horizons and portfolio manager for the $6 million Perritt Capital Growth Fund, agrees that it is now a favorable time for smaller stocks, since smaller firms will have improved bottom lines more quickly than the larger companies.

Ditching Pennies

Traditionally, smaller and start-up firms that could not get listed on the larger exchanges have traded on the OTC market, and the shares of these firms were listed on NASDAQ. But unlike the NYSE and other stock exchanges, which utilize an auction market, the OTC market relies on a negotiated market system (NASDAQ) to conduct its day-to-day business.

In the past, many investors dismissed the OTC market as a speculative arena for "penny stocks." However, many of the fraudulent firms that plagued the OTC years ago have been driven out of business. Tougher regulations on capitalization have been put in force by NASD.

Many of the issues currently listed on the NASDAQ system are growth stocks offered by new, modestly capitalized high-technology, medical and service companies. As these firms grow, many have chosen to remain on NASDAQ, even though they could qualify for the other exchanges. For the more volatile and less capitalized firms, NASD has two destinations of stocks: OTC and NASDAQ. OTC stocks, which include penny stocks, are issued by companies with an erractic history of earnings and are therefore more volatile. NASDAQ stocks are aggressive growth stocks that satisfy newly imposed, stringent NASD requirements for capitalization and have a stable track record.

In addition, NASD, which is under the sponsorship of the National Market System (NMS), provides continuous electronic transmission of the last sale price, as well as the volume information for certain NASDAQ issues. Stocks that trade on NMS must meet more stringent criteria than the upper 27,000 NASDAQ stocks.

Moving On Up

While there are many smaller firms on NASDAQ, the larger firms have also come aboard. "At one time, companies gained a certain amount of prestige among investors by moving their listings from the OTC market to the American Stock Exchange or to the New York Stock Exchange," says Pierre Dunagan, account executive at Dean Witter Reynolds in Matteson, Ill.

"Today, however, NASDAQ's reputation for quality is well-established and competitive, and many companies prefer to stay with NASDAQ," says Dunagan. Many small and start-up firms will continue to trade on NASDAQ, but so will well-known companies such as Apple Computer Inc., MCI Communications Corp. and Toyota Motor Corp.

NASDAQ is now the second-largest stock market in the United States and the third-largest in the world in terms of dollar values and shares traded. But boom or not, the question many investors are now asking is how long will NASDAQ's bull market continue to rage?

The case for small-cap stocks is stronger now than it has been at any time since 1983, giving investors the potential to add substantial growth to their portfolios. "I see no end in the bull market for small company stocks until 1994 at the earliest," says Jim Collins, publisher of OTC Insight, a 10-page monthly investment report in Moraga, Calif., which tracks 2,000 stocks and model portfolios for some 1,500 subscribers.

Granted, many investors have been frightened off by small stocks because of their perceived risk. However, NASDAQ could be considered safer than other stock markets in some aspects, says Dean Witter's Pierre Dunagan. For instance, the market is not subject to the wild one-day, buy/sell computer programs that have caused broad swings in NYSE and AMEX.

Several brokers point out that it is also easy to invest in NASDAQ listed stocks. You can just call and place your order and the transaction will be executed at a price or very close to the previous transaction. It will never be higher than the best offer or lower than the best bid.

Another way to get into the market and reduce your risk is through a mutual fund that deals in stocks of smaller companies. According to Lipper Analytical Services Inc., Summit, N.J., small stock funds have surged an average of 49.6% over the past 12 months.

Some funds have performed better than others. For instance, the Montgomery Small Cap Fund has soared 95.39% (as of Sept. 30, 1991), while Colonial Small Stock Index Trust is up just 15.4% "What we've seen is a substantial dichotomy between the more aggressive growth managers and the more conservative value managers," says Peter Schliemann of David L. Babson & Co. Inc. and portfolio manager of the Babson Enterprise Fund, a small stock mutual fund. To help spread out the risk, many portfolio managers recommend investors buying two or three different mutual funds.

It is impossible to forecast the future performance of the volatility of any stock, regardless of where it trades. Still, many financial experts believe that the future looks bright for NASDAQ issues.