A column published last week on Forbes.com reported Thompson analysts expecting stocks in the Standard and Poor’s Small-Cap 600 Index to return an average of 19% in 2006 and 16% in 2007. That tops predictions of 15% and 10%, respectively, for it’s big brother — the S&P 500.

While it’s important to view these predictions with a grain of salt, this could be seen as a testament to value investing. You see, like any index, the S&P 600 has specific requirements for its member companies. Aside from the obvious, like qualifying as a small-cap stock (with a market cap between $300 million and $1.5 billion in this case), the company must also face financial scrutiny.

For instance, in order for a business to make the cut, it must post at least four consecutive quarters of positive net operating income.

And these small-caps with decent fundamentals have scored big. The S&P 600 Index has returned 53% over the past three years, according to Forbes. The S&P 500 returned only 28% over the same timeframe.

There are some trading strategies out there that involve buying up new companies on the list. I’m not going to advocate such a system, but it is a good place to begin your research. “Index membership puts a stock on the shopping list of many fund managers, which is something that can be a plus to its share price,” writes Paul M. Murdock of Forbes . His people went through the list of new inductees and found companies with what they deemed attractive metrics. Kendle International and Sketchers USA are two that made the cut.

Breaking Down the Index

The people at Standard and Poor’s want the Index to be used by investors to find suitable small-caps with proven fundamentals, designing its listing as an “efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable. As a result, the S&P Small-Cap 600 is gaining wide acceptance as the benchmark of choice for both active and passive management. It makes up the final piece of the S&P U.S. Index Series that can be used as building blocks for portfolio construction.”

When divided into industry categories, it becomes apparent which sectors are thriving in the small-cap kingdom. In the 600, energy companies are up more than 16% this year, utilities have risen more than 14% and consumer staples (Hansen Natural and Playtex Products are two of the better known companies in this arena) are up more than 15%.

The worst performing sector on the 600 has been consumer discretionary, which has fallen about 4.1% so far this year. As I mentioned last week, the cost of living is increasing and many families are feeling the pinch.

As purse strings tighten, some of these companies in the consumer discretionary sector have not been faring well. Fitness center operator Bally Total Fitness (BFT: NYSE) shares have been crushed the past six months due to lower-than-expected memberships, failed buy-out plans and resignation of its CEO.

Take a look at what the past six months have done to Bally’s share price:

As you can see, things aren’t looking good for Bally these days. But going to an expensive gym rates pretty high on a list of luxuries that can be easily discarded for jogging or other free exercise-related activities.

Then we have P.F. Chang’s China Bistro (PFCB: NASDAQ). Take a look at the six-month chart:

While P.F. Chang’s met analysts’ expectations, it cut its 2006 guidance. Here’s the scoop from Business Journals: “P.F. Chang’s China Bistro Inc. Wednesday posted a 13 percent decline in second-quarter profits. The Scottsdale-based restaurant chain said higher costs offset a jump in sales resulting in net income of $8.1 million, or 30 cents per share, from $9.3 million, or 34 cents per share, in second-quarter 2005.”

P.F. Chang’s was down more than 2% in morning trading today.

Turnover

The S&P Small-Cap 600 is always changing. With recent additions such as Stamps.com (STMP: NASDAQ), PetMed Express (PETS: NASDAQ) and others, the 600 has to clean house to make room. Recent deletions include Power Integrations, Diagnostic Products Corp. and Laserscope.

You can browse the indices at Standard and Poor’s website, along with all of the sector information included in this column.

Remember, the 600 is a great place to begin your search for solid small-cap value plays, but just because a security is listed on the index does not mean it will always perform well and make you money (as you can see just by looking at P.F. Chang’s and Bally’s charts above).

As with any group of stocks, there will be winners and losers. I’ll sift through the list this week to see if you should put any on your watch-list.

Best,
Gunner
August 21, 2006

Riding the 600 was originally featured in the Penny Sleuth.