Health Care Replaces Tech as Investor Darlings

BOSTON ( TheStreet) -- Small-cap stocks soared to a record last week even as the economy struggles to find its footing, leaving investors to wonder how to adjust their portfolios as volatility ramps up before the summer doldrums take hold.

Mutual fund managers are telling clients to stick with large-cap stocks because they offer greater value.

The Russell 2000, considered the best benchmark of small-cap stocks, jumped to an all-time high last Monday, topping its previous record set in 2007. Since the low set in March 2009, the small-cap index is up more than 140%, outpacing a gain of less than 100% on the broader S&P 500 index. However, the Russell 2000 declined for the rest of the week as investors sold risk-laden stocks and commodities. Many investors are wondering if small-cap stocks have completed their run.

Flows into small-cap mutual funds show that investors are chasing the performance of small-cap names. According to data from Morningstar ( MORN), small-cap mutual funds have seen an estimated net flow of $13.2 billion since the March 2009 low, while large-cap counterparts have seen outflows of $105.7 billion. Fund managers -- even those who manage small-cap portfolios -- say greater opportunity exists over the long term in large-cap stocks.

Eugene Profit, manager of the Profit Fund ( PVALX) and the Profit Opportunity Fund ( PROFX), has a unique perspective as he manages both large-cap and small-cap stocks.

"The market has been rewarding excess risk more than capitalization with respect to stocks. If you look at the Russell 1000 growth, a lot of the returns have been driven by the smaller-capitalization stocks rather than the large-cap staple names," he says.

Profit says money continues to pour into small caps because investors chase what is working. The Federal Reserve's bond-buying program, an effort to support the economy, has rewarded risk-takers, pushing up commodities, technology stocks and small-cap companies.

"The Fed will maneuver away from excess liquidity it has provided and so investors haven't taken a different posture," he says. "When that happens, you'll see a reversion back to the mean with respect to large-cap securities. But until that happens, small-caps will at the very least share the limelight.

Elizabeth Jones, manager of the Buffalo Large Cap Fund ( BUFEX), encourages investors to spread their money across companies of different sizes. She says that, midway through the economic cycle, large-cap stocks begin performing better than small-caps. That's about to happen.

"Now as we sit here, we have a price-to-earnings multiple of nearly 30 on the Russell 2000 trailing. It's about 15 on the S&P 500," she says. "Looking forward into 2011, it's about 22 on the Russell 2000 and about 13 or so on the S&P 500. When you think about those multiples, large cap looks a lot cheaper. At this point, it seems reasonable to be increasing the weighting in large cap relative to small cap."

Jones points out that earnings on the S&P 500 are expected to grow about 13% from 2010 to 2011, compared to a 40% projected growth rate in earnings on the Russell 2000. "We're not going to say that's going to happen, but certainly there's a lot more risk in that number of 40% growth than there is in 13.5%," she says. "As the cycle progresses, further margin expansion becomes more difficult because companies have to invest for growth. Given the rise of input costs on top of that, it makes that 40% growth a little more difficult to obtain."

Both Jones and Profit have been favorable of large-cap stocks, particularly health-care names. They detail the best health-care stock picks in the portfolios on the following pages.

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