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. Last Updated: 07/27/2016

Small-Firm Stock Drop Sparks Investor Tremors

You may not have noticed, but over the past month the Russell 2000 index, which measures the stock prices of small U.S. companies, has dropped from 365 to 344. That's the equivalent of a 340-point drop in the Dow Jones industrial average. Is it an earthquake, as Cole Porter wrote, or merely a shock?

I'd call it an ominous rumble, and a good reason to look for safety.

The reason that many high-flying small-cap companies are dropping is very simple: They're too expensive. They're coming back to earth, and it hurts a lot more to fall out of a 92-story window than to trip down a step.

But the good news is that some of America's best companies aren't as high as the 92nd floor. Not only do reasonably priced stocks have shorter to fall, they have higher to rise.

A study for the National Bureau of Economic Research recently found that "earnings surprises" -- reports that quarterly profits were higher than analysts had predicted -- "are systematically more positive for value stocks," or stocks currently shunned by the market, than for what the authors call "glamour stocks," the expensive shares that the market loves.

Small-cap refers to a company's market capitalization, that is, the price of a share multiplied by the number of shares outstanding. Many small-cap companies actually have absurdly high caps, given their sales and profits.

In mid-May, APAC Teleservices Inc., a company that makes those obnoxious sales calls that interrupt Americans at dinner, was trading at $42 a share.

That meant that, according to investors, the company was worth about $2 billion -- quite a market cap for a business that last year earned just $8 million in profits. Now, a month later, APAC has lost a half-billion dollars of its market value.

Also in mid-May, the stock of Zoltek Cos., which makes carbon fibers, was worth $45. That made Zoltek's market value $600 million, even though profits were a mere $2 million on sales of just $13 million.

Today, Zoltek is down to $31, its market cap diminished by more than one-third.

But, even with these big declines, APAC has a price-to-earnings ratio of about 200 while Zoltek has a P/E of 125. Other lunatic P/Es abound. The average stock that trades over-the-counter on the Nasdaq Stock Market, home of go-go companies, currently has a P/E of 33, compared with 22 in December 1994.

Another way to measure a stock is to compare its price per share to its book value, or its net worth on the balance sheet. The average stock in the Standard & Poor's 500-stock index of large companies has a price-to-book ratio of 4.0, up from 3.3 a year ago.

Certain Cassandras of the financial newsletter business, such as Charles Allmon of Growth Stock Outlook and Dan Sullivan of The Chartist, have been screaming for years that stocks were overpriced. But they've kept rising. Now, however, the warnings are coming from different quarters.

Two weeks ago, subscribers to the Value Line Investment Survey, which has an impressive long-term record, were told to pare back their stock holdings to 55 percent, the lowest level since the firm began giving out this sort of advice eight years ago.

Despite these rumblings, you shouldn't abandon the stock market; it's where your long-run investment dollars should remain. But, in committing new money to equities, you should be wary of the APACs and the Zolteks and concentrate instead on good companies with low P/Es and P/Bs.