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Does glass slipper still fit for small stocks?

stocks, investing, small caps, S&P 500, Russell 2000 By Paul R. La Monica, assistant managing editor


NEW YORK (CNNMoney) -- If you root for small schools like Butler and against heavyweights like Duke in the NCAA tournament, this story is for you.

Small-cap stocks (the Wall Street equivalent of those pesky Bulldogs from Indiana) continue to lead the overall market higher.

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The Russell 2000 (RUT), one of the leading small stock indexes, is up over 20% during the past year compared to a 13% gain for the S&P 500 (SPX).

But some market experts are wondering if the glass slipper is about to fall off the small-cap Cinderella. Smaller stocks, as well as shares of mid-sized companies, have been outperforming the blue chips for about a decade now. That can't last forever.

Yes. there's still a case to be made for smaller stocks to lead. If the economic recovery continues to pick up steam in the United States, smaller companies should do better than their larger brethren.

That's especially true if debt problems in Europe, inflation woes in China and the aftermath of the earthquake in Japan lead to slower economic growth around the rest of the globe.

Smaller companies tend to have more of a domestic focus so their sales and profits are not as intricately linked to international markets as mega companies like Coke (KO, Fortune 500), Procter & Gamble (PG, Fortune 500) and McDonald's (MCD, Fortune 500).

With that in mind, earnings for companies in the S&P 600, another small-cap barometer, are expected to increase 28% this year, according to data from Thomson Baseline. Profits for the companies in the S&P 500 are forecast to rise 7%.

But the fact that smaller companies have slightly better growth prospects may already be baked into their stock prices. The S&P 600 firms trade at an average of 18 times 2011 earnings estimates, compared to a price-to-earnings ratio of just 14 for the S&P 500.

In addition, it's possible that the gap between small and large earnings won't wind up being as vast as expected because the U.S. economy is still not in tip-top shape just yet. Earnings estimates for small companies could be too high.

"The recovery in the U.S. is still muted," said John Toohey, vice president of equity investments with USAA Investment Management Company in San Antonio. "Many small caps have already rallied sharply and are priced for perfection."

Toohey said he is starting to gravitate more toward larger companies, such as oil giants Chevron (CVX, Fortune 500) and Royal Dutch Shell (RDSA), and big techs IBM (IBM, Fortune 500) and Oracle (ORCL, Fortune 500).

Still, these larger companies have to prove to the market that they can post strong growth rates. As I pointed out in Thursday's column, Cisco (CSCO, Fortune 500) is a great example of a large tech stock that has lagged because its fundamentals are uninspiring.

But Oracle is a different story. It reported its latest quarterly results Thursday. The software company's profits topped forecasts and Oracle issued a bullish outlook. Oracle also raised its dividend.

Shares of Oracle rose 3% Friday on the news. Despite that, the stock still only trades at about 14 times earnings estimates for its next fiscal year.

That's relatively thrifty for a tech company. And that's one reason why one fund manager who focuses on mid-sized stocks conceded that many larger companies -- especially in tech -- may be better bets right now.

"Look at large tech companies. Their stocks have spent a lot of the past few years in purgatory," said Stacey Serafini Thomas, co-manager of the Eagle Mid Cap Stock Fund (HMCAX) in St. Petersburg, Fla. "But they are cheap. So if they start demonstrating attractive growth, they can lead again."

Thomas said she still thinks some mid-sized and smaller companies will do well. But she's worried that the combination of high earnings expectations and takeover froth following a significant pick-up in merger activity this year has made many stocks too expensive.

She argues that increased M&A is better for large companies doing the buying than the smaller ones that may sell out since takeovers could juice profit growth for bigger firms.

But Paul Nolte, managing director of Dearborn Partners, an investment firm in Chicago, said investors shouldn't bail on smaller companies just yet. He said you can't ignore the fact that merger activity will lift small caps in the short-term even if deals benefit larger companies in the long-term.

Nolte added that as long as investors are worried about Japan and the Middle East, it's natural for small stocks to keep rising.

"Yes, smaller stocks have been outperforming larger companies for a while, but the global turmoil should help them," he said. "Not to sound overly glib, but the trend is your friend."

Reader comment of the week. Poor Research in Motion. The BlackBerry maker's week got off to a good start with an on-sale date and pricing info for its PlayBook tablet. But RIMM (RIMM) is down 11% Friday after issuing a disappointing outlook Thursday evening.

Eric Jackson, one of my favorites to follow over on Twitter, nailed it on Tuesday. Paraphrasing an amusing tirade from a former NFL coach that has resurfaced thanks to a reference in a not-so-amusing Coors Light commercial, Jackson predicted that RIMM's guidance would probably fall short.

"Guidance? Jim Mora would say, 'Don't talk to me about $RIMM and guidance'" he tweeted.

Ouch. To take it one step further, I'll paraphrase Mora yet again. "PlayBook! Don't talk to me about PlayBook! Are you kidding me?"

-- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.  To top of page

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