Size doesn't matter for stocks

NEW YORK (CNNMoney.com) -- 2010 has been, to quote Frank Sinatra, a very good year for the markets.

The S&P 500 is currently sitting on about an 11% gain, a healthy rise that's worth celebrating -- until you realize that this benchmark index, which mainly contains large U.S. companies, is drastically underperforming its mid-sized and small-cap siblings.

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The S&P MidCap 400 Index and S&P SmallCap 600 Index are both up about 24% this year. Another widely watched barometer of smaller stocks, the Russell 2000, is also up about 25%.

And guess what? Large companies may lag again in 2011.

Randy Bateman, manager of the Huntington Situs Fund in Columbus, Ohio, said that he thinks the gap between the performance of larger and smaller stocks could continue in 2011.

"The smaller and mid-sized companies are sucking up the return of the large caps," he said.

Bateman said the combination of more mergers -- smaller firms tend to be the most attractive targets for blue chips -- and faster growth prospects in a sluggish economy should keep the rally going for smaller stocks.

On the merger front, it seems like not a day goes by without a small or mid-sized company being acquired by a larger rival.

On Monday, for example, defense contractor Raytheon (RTN, Fortune 500) agreed to buy surveillance equipment maker Applied Signal Technology (APSG) for $490 million. Last week, Dell (DELL, Fortune 500) announced it was purchasing data storage company Compellent Technologies (CML) for $960 million.

It's worth noting that in both those cases, the acquiring companies used cash -- as opposed to their stock -- to finance the deals. And that makes sense. Many large businesses are sitting on immense piles of cash. Acquisitions are one compelling way to put that money to work.

"There will be big pressure on larger companies to use their cash. That favors small cap companies since more of them should get bought next year," said Pierre Lapointe, global macro strategist at Brockhouse Cooper, a brokerage firm in Montreal.

As for earnings, smaller companies tend to grow more rapidly coming out of an economic downturn. That still appears to be the case in the wake of the Great Recession.

According to data from Thomson Baseline, earnings for the companies in the S&P MidCap 400 and SmallCap 600 are each expected to increase more than 24% from this year. The estimated growth rate for the S&P 500, by way of comparison, is only 12% for 2011.

But here's what really could make the smaller companies more compelling heading into next year: Despite the higher growth rates, they aren't that much more expensive than their larger counterparts.

The S&P MidCap and SmallCap indexes trade at 16 and 17 times 2011 earnings estimates respectively, a significant discount to their projected profit growth. The benchmark S&P 500, however, trades at a slight premium to its growth rate: 13 times estimated earnings.

Lapointe warns that small caps may not do as well in 2011 as they did in 2010 however. But if history is any guide, they should still be better investments than large caps.

According to research from his firm, the SmallCap index has gained 7.2% on average in the second year after a recession during the past five recoveries, while the S&P 500 has gained 6.4%. The most recent recession ended in 2009.

The big gap in performance takes place in the first year after a recession though. Smaller stocks gained 26.8% on average while the S&P 500 was up 10%. So this year's strong run for smaller stocks should not be that surprising.

"This is a normal pattern," Lapointe said, adding that if anything, larger companies may have a slight edge over smaller stocks next year as long as the dollar remains relatively weak.

That's because larger companies with more multinational exposure benefit from a sluggish dollar since it boosts their profits when translated back into dollars and also makes their goods more attractive overseas.

Still, the dollar has been weak for large stretches of 2010 and that hasn't done anything to kill the performance of small caps.

Finally, larger companies, which tend to pay healthy dividends, may soon lose some appeal because of rising rates.

When Treasury yields were tumbling, it made more sense for investors to look to high-yielding blue chips as alternatives to bonds. But the yield on the U.S. 10-Year Treasury note is now about 3.3%, up from 2.33% just two months ago.

If rates continue to rise, investors may be less inclined to chase dividends and instead look to companies with higher growth prospects -- albeit lower dividend yields. The average dividend yield for the S&P SmallCap and MidCap is 0.9% and 1.2%, compared to 1.8% for the S&P 500.

"Before bond yields were heading up, there had been a lot of talk about demand for dividends. That is starting to die out a bit," said Craig Peskin, co-head of technical analysis research with MF Global in New York.

"Small caps have outperformed and I expect that to continue for now. I would not be betting against it," Peskin added.

Update: HP vs. Oracle I wrote on Friday about how Hewlett-Packard was the worst-performing stock in the Dow this year and that Oracle (ORCL, Fortune 500) continues to do no wrong in the eyes of Wall Street. I mentioned some of Oracle CEO Larry Ellison's more pointed barbs against HP (HPQ, Fortune 500).

HP emailed me Friday with some choice words for Ellison.

"Larry Ellison bought a money-losing business that had steady market share declines for years, and which still ranks at the bottom of the market," a spokesman for HP said, referring to Sun Microsystems.

"Customers aren't fooled by outdated benchmarks, no matter what Oracle says. HP's market share results prove it. Sun customers are running to HP in droves because they recognize we deliver superior technology, performance and pricing."

Wow. This is turning into tech's version of Ali and Frazier! Ding ding ding!

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