Thinking Smaller for Bigger Returns

Get small. Since 2000, the outperformance of small-cap stocks has been dramatic -- by several dozen percent, depending on which indices you're comparing. That means it's now starting to get the attention of investors and the media.

Beginning early in the cycle, I've been consistently pointing out the virtues of smaller-cap stocks in RealMoney columns. For example, here are a few quotes:

"Emphasize small- and mid-cap stocks in your portfolio." -- June 5, 2001

"It's all about ... small- and mid-cap 'real' companies." -- Aug. 27, 2001

"I continue to find the most exciting value in stocks with market caps of less than $5 billion." -- Oct. 23, 2001

Given the recent focus on smaller companies, it's reasonable to ask whether the cycle of small-cap outperformance is over. After all, shouldn't a contrarian lean against the wind and look for the cycle to end soon?

I think the answer is an unequivocal no. My guess is that outperformance of small stocks will take us to the end of the decade, at least. Here are a few reasons why:

Reversion to the mean: If you believe in cycles, as I do, then it's reasonable to expect that the rotation to small-caps from big-caps is a long-term trend. From 1984 to 2000, large-caps outperformed small-caps for 16 years, the longest run in modern market history. The next longest period of large-cap outperformance, from 1947 to 1958, spanned 11 years. That was followed, with impressive symmetry, by 11 years of small-cap outperformance. Since the latest small-cap rally only just started three years ago, after a 16-year large-cap rally, it seems safe to assume that small-caps will lead the way for the remainder of the decade or more.

Valuation: My work is valuation-specific. Although it tells me nothing about the market's short-term direction, I continue to find the most compelling values in smaller companies. The market doesn't price equities very efficiently in the short term, but it certainly does over the long haul. I expect the valuation disparity between large- and small-caps to be corrected over time. It could go much further than simply correcting the valuation gap; in an overshoot, small-caps could eventually become much more expensive than large-caps.

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At time of publication, Alsin and/or ACM was long Monaco, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, TheStreet.com Value Investor.