Despite the run on large-cap stocks and the relative unpopularity of small-caps, these investments still make sense according to a study by Undiscovered Managers Funds, a family of 11 separately managed mutual funds, each sub-advised by a small money management firm.

"Small company stocks have provided much greater investment returns than large company stocks since records were first kept in 1926," said Mark Hurley, president of Undiscovered Managers, which has just released the study -- Small Company Stocks Still Make Sense.

The study stresses that the performance gap between large-cap and small has always closed at some point, and closed very rapidly.

"One hundred dollars invested in small company stocks in 1926 would have grown to $397,538 as of March 31, 1999," said Hurley, "while $100 invested in large company stocks would have grown only to $257,532. More recently, $100 invested in small company stocks in 1960 would have grown to $13,336 as of March 31, 1999, with $100 invested in large company stocks growing only to $8,745."

But small caps have recently endured their worst five-year period of performance since 1926 when compared to large-caps. History suggests that investors may be acting emotionally instead of rationally in this period of investing as entertainment -- and those who sell their small company stocks now, in an attempt to time the market, risk dramatically reducing future returns.

The study also states that although the market has historically moved in cycles, the degree of outperformance by large company stocks during the past five years, and particularly the last two years, is difficult to explain.

"One of the most basic statistics used by investors to measure the value of a company is earning per share," said Hurley. "The higher the earnings per share, the more an investor is willing to pay for its shares. The recent movement of investors into large company stocks, however, appears to have little to do with the relationship between price and earnings."

"While the P/E ratio for large company stocks has increased from 19 in March 1997 to 31 in March 1999, the P/E ratio for small company stocks has actually decreased since October 1997. During the fourth quarter of 1998, the gap between P/E ratios reached its widest point in 20 years."

And this difference exists despite the fact that earnings have grown at almost identical rates for large and small caps during the past five years. In fact, small cap earnings have grown more rapidly since 1997 an increase from 14.3% to 18.3%, while large cap earnings have grown only from 15.0% to 15.9%.

Hurley concludes by saying that "nobody knows when -- or if -- small company stocks will once again outperform large company stocks. History, however, suggests that small company stocks will swing back in favor at some point -- and they will do it suddenly." 

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