In the spirit of the season, it's important to remember that good things come in small packages.

That's true in the stock market as well, where small-caps have ruled the market for most of this year. I don't think their outperformance is close to winding down. First of all, small-caps are still a better value than large-caps, a point I made in

my Oct. 4 column. Since then, small-caps have continued to perform relatively well.

In the month of November, small-caps, as measured by the Russell 2000, were up 7.75%, compared with a 1.1% return for the

S&P 500

. But now there's another reason to prefer small-caps: the "January effect." The January effect is a seasonal bounce in stocks that has occurred with surprising frequency over the past 80 years. According to recent work by the Merrill Lynch Small-Cap research team, history has shown that you can get a bigger bang for your buck by owning small-caps during January than by owning large-caps.

All signs point to a repeat performance of the January effect this coming year. The odds are in its favor to begin with. The Merrill team found that since 1926, the January effect occurs in seven out of every 10 years, or about 70% of the time.

On average, small-cap stocks have bounced higher, returning 2.6% in the month of January, compared with a 1.1% gain for large-caps. But when January follows a down year (as 2001 is likely to be, with the S&P 500 already off 14% so far this year), the odds are nine out of 10, or a 90% probability, that January will be up. And when that happens, small-caps outperform even more, rising 3.8% on average.

Satya Pradhuman, director of small-cap research at Merrill Lynch, says the likelihood of a strong January 2002 effect in small-cap stocks "feels right." The first chart below shows average January returns by market cap. Small-caps, even micro-caps, have demonstrated the best performance. The second chart shows that small-cap January returns are 120 basis points higher on average after a negative year for the S&P 500.

January Effect by Size
The smaller the cap the better

Source: Merrill Lynch Small-Cap Research

There is some logic behind why stocks, particularly those in the small-cap value category, hit the ground running as the year begins. Pradhuman broke his reasoning down into four categories:

    Human behavior changes at the start of the year. Pradhuman calls it the "closing-the-books effect." At the beginning of the year, many investors are looking to the future rather than to the past, and they may be more willing to commit money to stocks. Information flow is better. Small-cap stocks typically don't get as much news coverage as their large-cap counterparts, and these companies have to rely on their own press releases to disseminate information. Pradhuman says his studies show that "there are more news releases at the end of each quarter, and even more at the end of the year. Companies with good news tend to be more vocal about it then." Tax and accounting effects often set the stage for a January recovery. Especially in a down year, investors often sell their losers to offset capital gains they may have incurred. Pradhuman says this selling pressure can "exacerbate the trend of a down market." There is a rebound from oversold levels. Pradhuman thinks a January that follows a down year for the S&P 500 tends to post even stronger returns than average because depressed prices attract a new, more contrarian buyer who is looking for deals.

January Effect: Small-Caps
Better after bad year, like this one

Source: Merrill Lynch Small-Cap Research

But probability alone isn't a good-enough reason for me to buy a stock, and in this case, the fundamentals support small-caps as well. Even though small-caps have performed relatively well this year, with the Russell 2000 down just 3.5% in the year to date compared with a 13.4% slide in the large-cap Russell 1000 index, small-caps still represent better value.

The chart below plots the price-to-cash-flow ratio for small-caps divided by the price-to-cash-flow ratio for large-caps. Currently, at 0.83, small-cap valuations are off their lows, but still well below the historical average.

Relative Price-to-Cash Flow
Large-caps vs. small-caps

Source: Merrill Lynch Small-Cap Research

While there are plenty of choices in the small-cap value space, Pradhuman also highlighted a few sectors that I've been writing about recently. For example, he recently recommended that investors increase their exposure to basic industrials.

According to his work, small-cap basic industrial stocks are particularly cheap right now, selling at price-to-cash-flow ratios that are at a 50% discount to all small-caps. This compares favorably with the 25% discount the group has traded at over the past 12 years.

TheStreet Recommends

My choice in this space would be

Domtar

(DTC)

, a well-run producer of uncoated free sheet, where the supply/demand picture is best in the paper sector. Domtar trades at just 1.4 times book value. (I mentioned Domtar in

my Nov. 29 column on paper stocks.)

Pradhuman also listed a number of auto-parts suppliers that look attractive. (I recommended the group as a whole, mentioning

Lear

(LEA) - Get Lear Corporation Report

in particular, in

my Oct. 26 column.) Another smaller-cap name that I like is

American Axle

(AXL) - Get American Axle & Manufacturing Holdings, Inc. Report

, the leader in drive-line systems for light trucks and sport-utility vehicles. The company just announced new contracts with

DaimlerChrysler

(DCX)

for two future SUV programs, a good sign that it is diversifying away from

General Motors

(GM) - Get General Motors Company (GM) Report

, which represents more than 80% of sales. American Axle is selling at a P/E ratio of just 11.7 on 2002 estimated earnings.

Odette Galli writes daily for TheStreet.com. Before coming to TSC, Galli was a writer at SmartMoney Magazine. Prior to that, she worked as a senior manager at Ark Asset Management where she managed $3 billion in institutional assets. In addition, Galli was a senior vice president at J & W Seligman. She has also served as a research analyst for Morgan Stanley.

In keeping with TSC's editorial policy, Galli doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to

Odette Galli.