Small Vs. Big Cap Stocks

Small and mid-cap stocks have left the big caps in the dust over the past 15 years here in the
US. On a risk / reward basis, smaller caps are supposed to outperform the large, established
companies over the longer term, because the small fry aggregates contain those companies
destined to grow into much bigger companies. The preference of investors for small and mid-cap
US companies coupled with increasing diversification into foreign stock markets have played
an important role in turning  big cap measures such as the Dow 30 and SP 500 into sources
of funds over the past decade.

This year, as in the past five or so, many strategists are proclaiming that now is the time to move
out of the little guys into the bigs. Now there are some structural reasons for this optimism
centered around the poor performance over the years of many of the big cap techs like Intel and
Microsoft along with the more recent collapse of a number big cap financials such as Citi et al.
This is a good point, because there have been an unusually high number of big cap tank jobs over
the past decade.

Strategists also point to a good sized p/e ratio discount of the bigs when compared to the smalls.
This is a more challenging issue. Looking out through 2011, the SP 500 is trading at near 14x
earnings compared to near 17x earnings for the Russell 2000 ($RUT). But you have to be very
careful here. Realistically, you could project longer run earnings growth of 6.6% for the "500".
However, analysts have the Russell 2000 clocking out at 12.7% aggregate eps growth longer
term. It is proper to question whether the small / mid-caps can grow so much faster than the
major caps for years to come, and the issue would be critical if the p/e premium for the smaller
caps was much larger.

The best time to own the larger caps is when the p/e against the smalls is comparable to
that of the smaller guys, while the growth potential for the major companies is equal to
or greater than the smaller cap stocks. This does happen from time to time, and it occurs
most notably when there are big cap sectors with strong new product / services growth
such as occured with big techs and pharma some years back.

Now I also believe that the current US recovery could take a number of years to run, so
I am less skeptical of the projected earnings growth for the smaller caps than I normally
would be.

If I was running large pools of equity capital now as in the old days, I probably would be
reluctant to screen candidates on the basis of capitalization size at this juncture. I would be
inclined to let the economy run for a good couple of years before putting up  cap size screens.
I plan to return to this interesting but difficult issue in a few months.

View chart for a look at the relative strength of the Russell 2000 small cap vs the SP 500.
Note that there is currently rotation in favor of the big caps following strong end of year
2010 by the "2000."