Todd Ruppert of T Rowe Price believes that now is the time to evaluate the potential of these stocks

Historically, most European money managers have treated the US equity market as a monolithic, single entity to which a fixed percentage of a balanced portfolio should be allocated. In practice, this has meant that European investors have benefited only from exposure to large-capitalisation US equities, since large-caps are the most visible and liquid US equities.

Within the US, matters have reached the opposite extreme as investment firms have segmented and re-segmented the equity market into highly-specialised investment sectors. There are now more mutual funds than there are publicly-traded stocks in the US. Plan sponsors and investment consultants constantly scrutinise this sea of managers, seeking the outstanding performers in each specialised asset class.

Sorting through this heap of investment alternatives is indeed a monumental task. Yet it is a necessary one. While large-cap, 'blue chip' stocks have fuelled the astonishing performance of the US equity market over the past four years, recent market turbulence has driven home the basic axiom that no sector outperforms forever. European investors who allocate their US exposure solely to large-cap equities may suffer from substantial cyclicality in their returns from such a concentrated exposure-and may not get the broad-based US exposure they are generally seeking.

What Large-Caps Can't Do: As has become painfully clear since July, the high-visibility large-cap stocks of the Dow Jones Industrial Average and Standard & Poor's 500 Index are not, in fact, perfect representatives of the state of the US economy. While the US represents the largest single market for most large-cap companies, a significant portion of their revenues and earnings are derived from overseas sales-where growth has been swallowed up in a widening global recession. 'Blue-chip' companies like Gillette, Proctor & Gamble, Coca Cola and Microsoft are true multinationals. In many ways, this makes them attractive long-term investments. But these companies, while desirable, are more representative of worldwide trends than of the US economy. Thus, a US allocation that includes only large-cap companies is not, in fact, a true US allocation.

Even more importantly, by focusing on one narrow sector of the US equity market, investors may end up foregoing returns that could otherwise be earned. While it is true that smaller-capitalisation stocks are, in themselves, more volatile than their large-cap counterparts, especially in the short term, it is also true that, over time, periods of strength in the small-cap market tend to alternate with periods of strength in large-cap markets. By allocating assets among both small-cap and large-cap stocks, the cyclicality of returns within a US allocation can be smoothed and without incurring an unacceptable level of risk.

The Alternatives: In a US equity market that contains over 7000 stocks, only about 300 companies qualify as 'large-cap'-that is, have a market capitalisation of more than $7.5bn (a cutoff which is generally accepted, though subject to some debate). What about the more than 95% of the market that is left over?

Defining this universe of equities is trickier than one might suppose, with various consultants and analysts suggesting categories that can be notably different. However, most market experts will accept a definition that places small-cap equities in the range below $1bn in capitalisation, and mid-cap equities in the range between $1bn and $7.5bn.

These small- and mid-cap companies, for the most part, focus on the US domestic market for their revenues and profits. Smaller companies are also the drivers of most US job growth, and hence are a major component of domestic consumption. A small- to mid-cap investment far more accurately captures a US economic exposure than does a large-cap allocation.

Yet although the small- to mid-cap categories contain over 95% of all equities traded on the major US exchanges, these stocks account for barely 30% of total US market capitalisation. Why should so small a percentage of the market command an investor's attention?

In a word, performance. Well-managed smaller companies have better internal growth prospects than large companies in mature industries, and thus command higher price-to-earnings multiples once their ability to grow has been demonstrated. Historical research bears out this potential.

The historical case for investing in smaller company stocks was succinctly made by Claudia Mott of Prudential Securities, in her analysis of data from the University of Chicago Center for Research in Securities Prices. Since Mott's original study in the early 1990s, T. Rowe Price has continued to update the study's data. The results: small-cap stocks returned an average of 11.95% per year, versus 9.94% for large-caps. Compounded over time, that 201 basis points becomes a tremendous performance advantage.

And, as noted, this strong performance tends to occur in cycles that counterbalance periods of outperformance by large-cap equities. This point is best made by looking at actual investing experience. Because the most widely-used index of small-cap performance, the Russell 2000 Index, has only been in existence since 1978, those who are interested in longer-term small-cap performance have traditionally looked to the T. Rowe Price New Horizons Fund for empirical data.

New Horizons, which was established in 1960, is a growth-oriented small-cap fund.Over time, the price to earnings ratios for the stocks in New Horizons have typically been in the range of 1X to 2X the ratios of large-cap stocks. [See Chart 1: 'P/E Ratio of Fund's Portfolio Securities Relative to the S&P 500 Index P/E_Ratio.'] Periods of rising relative price to earnings ratios indicate periods during which small-cap stocks outperformed large-caps; conversely, as relative P/Es drop, small-caps underperform.

Table 2 shows the magnitude of these cycles in terms of total return performance. Performance spreads between the two asset categories have at times exceeded two hundred and fifty percentage points. Such huge cyclical disparities underline the need to be invested at both ends of the capitalisation spectrum. It is also worth noting that the three widest spreads over the past 38 years have all favoured small-cap stocks.

A crucial point to notice here is that the four major cycles of smaller company outperformance-beginning in 1964, 1970, 1976, and 1990-coincide with periods when the price to earnings ratio for these companies approached parity with those of large-caps (1.0 on the chart). As of September 1998, the relative P/E of smaller companies had reach 0.96-the lowest relative P/E on record since New Horizons was established. This indicator tells us that we may be poised to begin a new cycle of strong smaller company outperformance.

Where to Start: Successful smaller company investing is based upon recognition of solid growth opportunities, and management of the inherently greater risk that such opportunities carry. The truism most often quoted for small-cap equities is simple and stark-'Companies either grow up or blow up.' The key to a growing portfolio is individual company research.

A major reason why small-cap equities tend to outperform large-cap equities over the long term is because the immense and constantly-changing market of smaller companies is so inefficient relative to the large-cap universe. Large companies are the focus not only of analytical scrutiny, but of regulatory and public scrutiny as well. No event is overlooked, and information is instantly disseminated.

While smaller publicly-traded companies in the US are held to the same high reporting standard as the large companies, sheer numbers ensure that not every company receives a similar level of scrutiny. A regional company in an unremarkable (though profitable) line of business is unlikely to garner any but hometown-paper attention from the press or public, and often no major research or brokerage house has assigned an analyst to track the company. Companies under a $1bn in market capitalisation, for example, average fewer than five Wall Street estimates, as compared to more than 20 estimates per large-cap company (according to I/B/E/S data). Many companies have no Wall Street coverage whatsoever. The information is there-but often, no one is looking.

It takes a significant commitment of firm resources to assemble a credible and effective research team for smaller companies. Experience and a strong network of contacts count for a lot in this area. A hands-on approach-visiting companies, touring their operations, meeting with both senior managers and workers on the line, talking with suppliers and competitors, and participating in conferences and seminars where industry trends can be spotted-is critical for uncovering the hidden value that marks a small-cap winner. A successful smaller-company research effort requires being there. A lack of analytical presence in the US is perhaps the biggest reason why European-based managers have avoided investing their clients' money in US small- and mid-cap equities.

Team experience and a strong network of contacts matter, not only in uncovering hidden value, but in uncovering hidden risks. Smaller companies often do not have lengthy operating histories, and many attractive opportunities are in industries that are themselves brand-new. In such situations, risk cannot be quantified in a neat computer model. Experienced judgment based on solid

information becomes the best hedge against risk.

An investment manager who can support these dedicated research resources is best placed for achieving outperformance over the long term.

Mid-Caps: Even when a manager can offer solid smaller-company research and an experienced investment team, however, the volatility of small-cap stocks can be too high for some investors to tolerate, especially those with relatively short time horizons. The University of Chicago data which demonstrated small-cap outperformance also showed that small-cap stocks had a standard deviation of 30.89%, versus 19.16% for large-caps. Some small-cap stocks are also very thinly traded. This inefficient market is one of the reasons why so much opportunity can be found in the small-cap area, but it also means that some investments can be relatively illiquid.

Seeking a systematic way to participate in the growth potential of smaller companies while reducing the inherent risk of small-caps, the investment community has, over the past decade, developed a market sector now widely accepted by consultants and investors. Mid-cap equities are now tracked by several recognised indices, most notably the S&P MidCap 400 Index (established in 1991).

Mid-cap equities, as noted, are those with a market capitalisation between $1bn and $7.5bn. Many of these companies have 'grown up' through the small-cap ranks, and therefore have significant operating histories and proven business concepts. Mid-caps also tend to have higher trading volumes, making them more liquid investments. The mid-cap market is thus more efficient than that of small-caps, but still less efficient than that of large-caps, leaving substantial room for opportunity.

The Prudential/University of Chicago study shows that, over the long term, mid-cap equities outperform large-caps by about 150 basis points per year, capturing a substantial portion of the small-cap premium. Yet volatility, at a standard deviation of 25%, was substantially less than the small-cap average. Note, too, that with only one exception, both small- and mid-cap equities have outperformed large-cap equities, decade by decade, since World War II.

It is this kind of performance that has created the rapid acceptance of the mid-cap asset class among investors and consultants alike, and which ma-+kes mid-caps an attractive way to participate in US smaller-company investment for those European investors who are more risk-averse.

Why Now? As of this writing, in mid-October, the widely-followed Russell 2000 Index benchmark of smaller-company performance has fallen more than 35% from its high in April of 1998. In fact, the performance spread between the Russell 2000 Index and the S&P 500 Index for the 12 months ended 30 September 1998 is wider than it has ever been, with the Russell 2000 nearly 30 percentage points below the S&P 500.

Given the scary pummeling all US equities took at the end of the third quarter, especially small- to mid-cap equities, why should investors be looking at this market now? Consider the following:

* Earnings growth continues to be strong-over the past four quarters, research by the Leuthold Group shows that earnings growth for smaller-companies has been consistently greater than that of large companies. Wall Street forecasts continue to place smaller companies significantly ahead in coming quarters.

* Valuations relative to large-cap stocks are at historic lows-as noted, the P/E ratios of small-caps relative to large-caps has reached an all-time low, and similar lows are being reached by relative price to cash flow and relative price to sales ratios. Such lows have a high historical probability of being followed by strong and sustained outperformance by smaller company stocks.

* The supply of new smaller-company issues has dried up-lack of new supply creates stronger demand for existing small- and mid-cap stocks.

* The current cycle of small-cap underperformance is now over four years old-in the context of a typical down-cycle duration of between four and five years.

In short, both technical and fundamental indicators show that the small- and mid-cap equity markets are potentially poised to begin a cycle of outperformance. No prudent adviser would pretend to know the exact moment when a market has bottomed-but, unquestionably, now is the time for investors to begin evaluating the opportunities available to them in the US equity market, and to consider how to position their portfolios to take advantage of those opportunities.

Todd Ruppert is a managing director of T Rowe Price Associates, Inc. John H Laporte, CFA and Preston G Athey, CFA, CIC, senior small-cap portfolio managers for T Rowe Price, contributed to this article.