(MONEY Magazine) – For the last four years, practically all that investors have cared about, outside of the Internet, are large-caps, megacaps and ultracaps. The bigger the stock, the better. There was good reason for this. First, big tech companies and consumer-goods makers were increasing sales and earnings. Then, starting in the summer of 1997, Asian, and later Russian economic woes sent institutional investors flocking to these stocks in what was termed a flight to quality. The thinking was that these global powerhouses offered liquidity--the ability to easily buy and sell large blocks of shares--and thus safety, just in case the global economy turned out to be much worse than anyone feared. Sure, the big stocks dipped a bit, but they bounced back higher than before. Even Coca-Cola stock, which hasn't rebounded to its old highs in the face of declining earnings, has grown more expensive if you use its rising price-to-earnings ratio as an indicator. Wall Street is just valuing the earnings Coke has more dearly.

How expensive are big stocks? The S&P 500 companies carry a price-to-earnings ratio of 30, based on the past 12 months' earnings, yet they're expected to increase earnings by just 7% this year and 4% next. Compare those numbers with 1996, when these companies were expected to increase earnings by 9% but carried a P/E that ranged between only 15 and 19. Even more problematic: Their revenue growth, which over the long term is the only way to keep profits rising, is expected to be near zero for the second year in a row.

So what's a more reasonable alternative for growth-oriented investors? We suggest you look to midcaps--which comprise 1,200 mostly domestically oriented, often brand-name companies (Hertz, Wendy's, Saks) that have market capitalizations of $1 billion to $10 billion. "We look at the universe of stocks and go where the growth takes us, and right now we are shifting to midcaps from large-caps," says Jim Grefenstette, manager of the $750 million Federated Growth Strategies Fund.

Looking ahead, the benchmark index of mid-size companies, the S&P 400, is predicted to grow earnings by 12% annually over the next three to five years, according to Zacks Investment Research in Chicago. Yet the average P/E for this set of stocks, based on estimates for 2000 earnings, is just 14. (See the chart, above.) That means midcaps should give you faster earnings growth than large-caps at about half the P/E. Such a disparity is getting harder to justify at a time when the global economy seems to be improving again. In a period of stability, the added liquidity large-caps offer will likely become less important to institutional investors, argues Salomon Smith Barney's chief equity strategist Marshall Acuff.

Wall Street has hardly jumped with both feet into midcaps just yet, but that's where the opportunity lies. Acuff is on board, and if history is any guide, he's a Wall Street big thinker worth your attention. In 1994 he suggested that investors move money to larger-capitalization companies just before big-caps took off. Now he's telling his clients to shift assets to midcaps. (See the interview with Acuff on page 54C.) Institutional money manager James Gribbell with David L. Babson & Co. agrees. "The percentage of our portfolio in midcap growth companies has been increasing over the last five months," he says. "We've been making a concerted effort to scale back on larger-caps that seem to defy gravity."

Mutual fund investors can find top midcap growth funds in our Money 100 report on the world's best mutual funds, which begins on page 83. As for individual midcaps worth considering, we used a tough set of screens centered on earnings growth to come up with our recommendations. First, we looked for companies that have been increasing profits and revenues at an ever-faster rate over the past five years and that are expected to increase earnings over the next three to five years by at least 14%--two percentage points higher than the average midcap. We eliminated companies with poor financial strength as measured by Standard & Poor's, as well as those whose earnings estimates had been lowered in the past six months. That left us with 10 stocks. We then used what's known as the PEG ratio--a company's P/E divided by its projected earnings growth rate--to screen out stocks that we felt were already expensive. We set our PEG screen at 1.25, about the average for mid-size growth stocks. That knocked out two well-known names, Hasbro and Harley-Davidson, from our list. Only eight companies remained, six of which operate in industries where fortunes tend to be won and lost on the the latest trend--for instance, Brinker International, a restaurant company, and Electronic Arts, a software maker for the teenage market. They may turn out to be excellent investments but seemed riskier than our final choices.

The first is Protective Life, a multiline insurer that has delivered steadily rising performance for the past five years, averaging 20% operating earnings growth. The Birmingham, Ala. company is also an efficient manager of its capital: it ranks in the top 10% of major life insurance companies in return on equity. The massive consolidation in the insurance industry plays into Protective's strength. One of the company's main growth strategies is to buy blocks of policies at cut-rate prices from companies looking to exit business lines. Protective, which has 170 people devoted to this business, has figured out how to administer these policies for as little as a third of what its competitors spend, says analyst Colin Devine of Salomon Smith Barney. And, of course, these policy blocks are leads for new sales. "Protective is a meat-and-potatoes story," says Terry Milberger, manager of the Security Benefit Equity fund. "They're good at what they do, with no big surprises."

But the company also isn't afraid of a little daring. It has partnered with the Lippo Group of Hong Kong to sell insurance policies in Asia and could be selling in China next year. At a recent $38 a share, Protective trades at 14.5 times expected 2000 earnings; its projected long-term earnings growth rate is 14%.

Houston-based BMC Software would not have been a candidate for this story last summer when it traded at $60. Back then it was a large-cap stock, with a market capitalization of $13 billion. But Y2K fears have crushed any stock, including BMC, having to do with enterprise software, the million-dollar systems that run accounting, inventory and other critical applications for large businesses. Information technology officers aren't inclined to make such big expenditures on new systems when their most important task is making sure their existing ones won't falter when the calendar turns. However, not all companies selling to the corporate market are alike. BMC doesn't make the huge packages sold by PeopleSoft and SAP. It makes less complex software designed to ensure that those programs work and provides early warnings and back-up when they fail.

"We've not heard our customers say to us that they are going to stop buying. So the Y2K issue, for us, is more overblown than real," Bill Austin, the company's chief financial officer, said in early April, as the stock languished around $32. In fact, the company announced earnings of 47[cents] per share on April 27, 4% above what analysts had expected.

"The Y2K issues will be over within nine months, and the market will discount them long before that," says Tom Giles of Thomas Johnson Investments, an adviser to the UAM Funds. He has been buying the stock in the 30s. BMC is trading at 20 times the $1.90 per share it is expected to make next year, while it is projected to increase earnings at 27% annually over the next five years. "In the high 50s, the stock was priced to perfection," says Chuck Phillips, Morgan Stanley Dean Witter's highly rated enterprise software analyst. "At these prices we're willing to live with the blemishes, in our belief that BMC has emerged as one of the longer-term drivers of the system management industry." --PABLO GALARZA