Canadian small-capitalization companies have significantly outperformed their larger peers since the beginning of last year. This is also the case in the U.S. The development contrasts sharply with the valuations given to large and small companies over the past few years.

It is appropriate for institutional investors to question whether this trend is merely an isolated blip or a more long-term change. If the latter is true, there is certainly a solid case for investing in smaller companies.

Historically, investing in small-cap stocks has not been as rewarding as investing in larger companies. Examining large- and small-cap indexes over time shows that, in general, stocks with lower market capitalizations have underperformed relative to larger ones. This trend was particularly marked over the past few years, when multiples in certain sectors propelled even relatively new companies to extremely high valuations.

In the minds of many investors, rapidly changing consumer markets would ensure that a few firms captured enormous market share, leaving no room for small competition. This thinking justified the payment of huge premiums over traditional valuation metrics, as it was assumed that these companies would have profitable growth over a significant period of time.

However, towards the end of last year, a number of high-profile stocks began to miss their earnings projections. Incumbent firms responded aggressively to the competition from new companies, and the economy started to lose steam after several years of uninterrupted growth. With many stocks priced to reflect perfect valuation multiples, there was a growing realization that the future might not be as predictable or rosy as investors had initially anticipated. Indeed, there was a widespread collapse in valuations.

It is overly simplistic, though, to say that all large-cap stocks were simply overvalued and a straightforward market correction resulted in this year's underperformance relative to small companies. In Canada, large-cap stocks lost, on average, 12.7% of their market value during the first six months of the year. In contrast, the CIBC World Market Small Cap Index shows that small-cap stocks gained more than 11% over the same period.

In the interest rate-cutting phase of an economic cycle small-caps have tended to perform better than large stocks in Canada. This is also true in the U.S. As the economy slows down and monetary policies are adjusted accordingly, we should expect to see small-cap stocks outperforming their larger counterparts to a certain degree. This contrasts with the performance of large-cap stocks over the preceding period of virtually uninterrupted growth.

What is likely to happen in the future? A number of factors, including historical data, suggest that we may see small-caps continue to outperform large-cap stocks. Despite the decrease in large-cap multiples since the start of the year, these stocks, on average, are several points higher than current small-cap valuations.

There are variations among sectors, though. Some small-cap sectors are trading at multiples that are 50% lower than large-cap companies in the same industry. There are sectors where small-cap stocks are trading at richer multiples than larger-cap firms.

But overall, across all sectors, small-cap stocks are trading at a discount. This discount is currently higher than the historical averages observed over both the short and long term. When coupled with higher projected relative growth rates for small-cap relative earnings, this indicates that the present period of outperformance may extend for some time.

Over the long term, however, performance will be determined, in part, by institutional investors' appetite for a given asset class. Typically institutional management performance is assessed on a relative basis--a manager will be deemed successful if he or she can beat a given benchmark in a set period of time.

A fund manager who chooses to invest in Canadian equities is likely to be benchmarked against the performance of an index such as the Toronto Stock Exchange 300 composite index. In turn, the index's performance is typically driven by a few key stocks. To match the performance of the index, a manager usually invests in securities that reflect their weighting in the index.

While an index fund can match the index perfectly, an actively managed fund can not. Transaction costs, liquidity and preferences with regard to valuation methodology and management style all come into play. As well, there are limits on the position a manager can take in a given stock. For example, the manager may be prohibited from owning more than 5% of a given company or investing more than 8% of his or her fund in a particular security.

A fund manager with responsibility for a general equity fund will typically allocate a greater proportion of resources to large-cap names than small-cap ones. This means that brokers and other providers of investment research will be more likely to produce analytical work relating to large-cap stocks as the bulk of their clients are interested in that area.

Ultimately, in an efficient capital market, a company's stock market performance will track its fundamentals. A rich multiple gives companies more flexibility in using stock as currency for mergers and acquisitions. In the case of some early stage growth companies, it is a means to finance expansion. But how closely the investment community follows a company should not impact the execution of its business model. If the model is strong, the company should be successful.

Good companies can perform well regardless of whether they are well known in the investment community. As well, the period of time it takes for strong operating performance to be recognized by the stock market is highly variable. Fundamental research is important in the small-cap area, because the higher the variability of returns, the higher the risk-reward trade-off. A larger and more complicated market emerges as the size of companies within the universe declines. This also increases the need for research and analysis.

There is a place for small-cap stocks in any balanced portfolio, regardless of market ups and downs. Current market conditions favour small-cap stocks. However, greater volatility and a shortage of detailed research on the overall sector mean that care must be taken with stock selection in this area. Indeed, the current outperformance of small-caps has not removed the element of risk. BC