It's a small (cap) world after all

NEW YORK (CNNMoney.com) -- Want to know if all this talk of an economic recovery is for real? Don't think big. Think small.

Small-cap stocks, which are generally considered to be companies with a market value of under $2 billion, have been outperforming their larger peers since the market bottomed. And the trend is picking up this year.

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The Russell 2000, a key index for smalll-cap stocks, has done much better than the S&P 500 over the past year.

The Russell 2000 and S&P SmallCap 600, two of the most widely watched barometers of small stocks, have each shot up about 8% this year. The S&P 500, by comparison, has gained just 3%.

That could be a good sign. Typically, the corporate equivalents of David will do better than the market's Goliaths at the beginning of an economic upturn.

Jeffrey Saut, chief investment strategist for Raymond James in St. Petersburg, Fla., pointed out that smaller companies have been reporting better profits so far this year.

"Many of the earnings surprises have been centered on smaller companies instead of large caps. The troops are rallying while the generals are stalling," he said.

That makes sense. Smaller companies are often able to post stronger levels of earnings growth than larger firms as the economy starts to recover.

Simply put, it's easier for more nimble companies to benefit from any pickup in spending. Analysts expect that to continue.

According to figures from Thomson Baseline, analysts are forecasting that profits for the companies in the S&P SmallCap 600 will jump 52% this year. Companies in the S&P 500 are expected to post an earnings gain of 19%.

Matt O'Reilly, chief investment strategist with Bridgeport, Ct.-based People's United Wealth Management, pointed out that another reason smaller companies will rebound more quickly is because many of them downsized so dramatically in the past two years.

"With all the lay-offs and cost cutting, small companies are in better financial shape than they were before the recession. Any incremental gain in sales should go right to the bottom line," he said.

The surge in shares of smaller companies also could reflect that investors are again willing to take on more risk instead of sticking with more tried and true blue chips.

It's also worth noting that several savvy private equity firms are on the hunt for takeovers again -- and many of them are scooping up small caps.

Thomas H. Lee Partners, the buyout firm most well-known for buying Snapple on the cheap in the 1990s and later selling it for a huge profit to Quaker Oats, announced last month it was buying fast food chain CKE Restaurants (CKR) for $928 million.

Also last month, a group of private equity firms led by Bain Capital agreed to buy e-learning company SkillSoft (SKIL) for $1.1 billion.

According to reports, Bain is now in discussions to buy mental health clinic operator Psychiatric Solutions (PSYS), which has a current market value of $1.6 billion.

This month, private equity shop CCMP agreed to buy Infogroup (IUSA), the parent of Internet lead generator Salesgenie, for $460 million. And cable company RCN (RCNI) sold itself to private equity firm ABRY Partners for $1.2 billion.

If the so-called "smart money" is sniffing around for bargains among smaller companies, that could be a show of confidence in the U.S. economy.

Saut mentioned that many private equity companies are still sitting on large piles of cash that they will want to put to work. That's why he thinks more deals will be in the cards -- and that should continue to boost interest in small caps.

Quincy Krosby, market strategist with Prudential Financial, added that larger companies may also join the merger fray. She said many health care, technology and energy firms have a healthy cash cushion they can use for takeovers.

Big Pharma firm Abbott Laboratories (ABT, Fortune 500), for example, announced on Tuesday that it was buying Facet Biotech (FACT) for $722 million in cash.

Krosby thinks larger companies may reclaim the market lead once there is more clarity about when the Federal Reserve and other central banks around the world will raise interest rates. But she said there is plenty of room for small caps to run now that the deal market is healthy.

"Large caps should outperform eventually but this is not a textbook recovery," Krosby said. "Merger activity picking up is absolutely a major catalyst for small caps."

-- The opinions expressed in this commentary are solely those of Paul R. La Monica.