For a long time, small-cap funds were like struggling actors: A few got leading roles, but most were playing bit parts.

But over the last three years, the group has taken center stage. According to Frank Russell Co.'s U.S. Equity Indexes: Year-End Report, small caps barely outpaced large caps in 1999 for the first time in six years and went on to outperform significantly in 2000 and 2001. Last year, the Russell 2000, a widely quoted index of small-company stocks, gained 2.5%, while the company's yardstick of large caps, the Russell 1000, dropped 12.5% and the S&P 500 fell 11.9%.

"Small caps outperformed large caps in every sector, regardless of how well the overall sector performed in 2001," says Dennis Jensen, a Russell senior research analyst. "Small caps typically perform well in the early stages of an economic recovery, which investors were anticipating in the fourth quarter."

Since early 2000, he adds, investors have seemed to see small caps as undervalued. "They saw a lot less valuation risk in small caps, which benefited those stocks as the overall market went through an extreme price compression."

Although small-cap stocks as a group have bested large caps during the last three years, it has been small-cap value that has been driving the numbers. The Russell 2000 Value Index returned 14%, 11.3% and 11.2% for the one-year, three-year and five-year periods, respectively, ending December 31. Those numbers compare with -9.23%, 0.25% and 2.87% at the same intervals for the Russell 2000 Growth Index.

But growth picked up steam in the fourth quarter, outperforming at every level-large caps, mid caps and small caps-according to Russell's year-end report. "The huge divergence in returns among sectors, cap sizes and styles over the quarter and the last several years shows the difficulty and added risk of trying to pick the best-performing market sector or segment," says Jensen. "The market again demonstrated that, to achieve consistent returns, it is prudent to diversify across multiple managers and sectors."

Still, with small caps out in front, a lot of people would love to know how much upside remains. Many observers are optimistic the country is headed out of recession, which they say typically leads to price appreciation for small caps. Although the Russell 2000's P/E ratio at December 31 was a hefty 37.9, compared with 29 for the Russell 1000, if negative earnings are excluded, the picture changes dramatically-the Russell 2000 falls to 18.7 versus 23.7 for the Russell 1000.

In recent history, valuations looked lowest at the end of 2000, because equity prices had dropped, but earnings hadn't declined yet, Jensen said. The market slumped following the terrorist attacks, but since the end of September, valuations jumped because of rising prices and declining earnings, he notes.

P/Es excluding negative earnings are more representative of value, but they don't tell the whole story, Jensen says. Looking at price-to-book value ratios is helpful, too, because they tend to be more stable. At December 31, the P/B ratio for the Russell 2000 was 2.12, which is lower than it's been over the last few years (it hit a low of 1.81 in September), an indication small caps are cheaper than they have been, he says. Meanwhile the P/B ratio for the Russell 1000 at December 31 was 3.55.

With small-cap valuations lower than they have been, many portfolio managers are optimistic about the opportunities small companies can offer investors. Chuck McCurdy, co-portfolio manager of ABN AMRO Veredus Aggressive Growth Fund, says small caps should continue to do well this year. "The five-year number on the S&P 500 ended December 31, 2001, was 10.7%, and that includes the good years of 1997 and 1998. The Russell 2000 was only up 7.5% in that period of time, and if you look at the Russell 2000 Growth, it's up only 2.9%. So if you look at the small aggressive names over the last five years, they have lagged, so I certainly think there's upside here," he explains.

McCurdy says he has become more selective and has redeployed some money from tech to energy and health. "We were buying names aggressively as the market was making its low in September, but we've reached the point in some names that we don't have a lot of conviction that things are sustainable." However, he thinks overall short-run market expectations are too low. "Most earnings reports are good, which is fuel for the market to move higher," he says.

The growth-oriented manager says he looks for companies that are exceeding earnings expectations. Once a company has a history of beating forecasts, it will pass Veredus' screens, and the fund builds its own in-house expectations. "We're trying to get a handle on positive earnings surprises and upward growth," he says.

Although he thinks the economy this year will be better than expected, McCurdy says the picture will improve when loan demand picks up. "We want to see it rebound, and then the economy will perform a little better," he adds. Recently, his fund's top three holdings were Overture Services, the former; Cytyc Corp., a medical device company; and DoubleClick Inc., which provides services to online advertisers and publishers.

Roger G. Vogel, Credit Suisse's head of U.S. value equities and manager of its Small Cap Value Fund, expects small caps will perform better as the country comes out of recession because they are more economically sensitive. He thinks based on valuation, small-cap value stocks have an edge over other equities. He also thinks the accounting nightmares uncovered at Enron and other companies won't impact small companies as much as large ones.

"My perception is small-cap stocks are less likely to play the restructuring game," he says. "I think we sort of all got a little bit sloppy by the market being so generous to everyone for the five years ending in 1999. You started to see things that looked a little odd-all the pro forma earnings calculations and questionable accounting practices. Now we've had two down years in large caps and a less vibrant economy and all of that is coming back to roost."

He predicts investors will take a little closer look at their investments in the wake of the Enron scandal, and that bodes well for his approach-finding quality companies with good balance sheets that are well-capitalized and generate strong cash flow. Some of his fund's largest holdings are Ametek Inc., a diversified industrial company, and Banta Corp., a Wisconsin-based printer.

G. Kenneth Heebner, manager of the CGM Focus Fund, also thinks small stocks offer more potential than big ones. "I believe we're going to see a consumer-led business recovery in 2002 and 2003, and a lot of companies the fund owns will benefit," he says.

Heebner has concentrated 25% of his fund in home builders, 13% in motor-home companies and 12% in the airlines. "I do this because if I think a sector offers unusual potential, I will concentrate to capture the opportunity," he says. He thinks many home builders in particular are growth companies with low valuations.

National home-building companies have very significant advantages relative to smaller competitors, but they have only 15% of the market share and are growing a lot faster than the whole, he says. One home builder he likes is NVR Inc., which operates in the Baltimore-Washington area and is expanding into Pennsylvania. Frontier Airlines Inc., based in Denver, and Continental Airlines Inc., based in Houston, are two that he thinks have potential and will benefit as the economy improves.

John Buckingham, manager of the small-cap value Al Frank Fund, is convinced small caps have a lot of life left. "If you look at history, the period for small-cap outperformance is four years," he says. "So far, we're up to seven quarters. From a valuation perspective, small-valuation stocks should trade at larger multiples because there's far greater upside as far as growth."

His fund is tech heavy because he believes tech offers the most value at the moment and has the greatest chance to gain. Lately, the fund has been buying-gasp!-some Internet stocks, including Via.Networks Inc., an Internet-services provider. Before September 11, the fund's largest holding was InVision Technologies Inc., which makes explosive-detection systems and was trading at about $3 a share. In early February, the company was trading at about $40 and was still the fund's largest holding. The fund's second-largest holding was Forgent Networks, a videoconferencing company, followed by Michael's Arts & Crafts.

Mark Genovise, manager of Driehaus Small Cap Growth Fund, expects small-cap growth to do well this year, but the improvement won't happen overnight. "We need more improvement in business fundamentals, and when that happens, we think that will be more conducive for small-cap growth stocks to do better." He noted small-cap growth has been doing better than value since September, but more robust performance won't come until the economy gets better.

Meanwhile, Genovise says, he's trying to be very selective in the stocks he chooses. The fund tries to focus on the near-term momentum individual equities have to offer, as well as cutting losers fast and letting winners run. He thinks the tech sector is showing signs of weakness, but the fund is finding some companies that look promising. Among them are Genesis Microchip Inc., which makes computer chips for flat-panel computer screens, and ESS Technology Inc., which makes semiconductors for DVD players, he says.

David Kern, manager of the growth-oriented Fremont U.S. Small Cap Fund, agrees economic hurdles remain in the United States as well as worldwide, but he thinks we are getting close to a point where small-cap growth will enjoy a sustained period of outperformance. "Growth in many respects had been out of favor up until the fourth quarter. There still are challenges, but I think as I look at the intermediate term, I get excited about the opportunities," he says.

Kern adds the fund, which is concentrated in tech, health care and consumer products and services, looks for innovative companies to buy. "In order for a small company to produce high rates of revenue and profit over a period of time, they have to offer something new and different. They have to offer something that companies with bigger pockets aren't offering," he says. Kern believes one such company is Riverstone Networks Inc., a pioneer in metropolitan-area networking. Another company he likes is Pharmaceutical Product Development Inc., a clinical research company.

William J. Wolfenden III, manager of RS Smaller Company Growth Fund, also sees some positive signs on the horizon for small caps. "When the economy does pick up and resources pick up, it tends to drop them at the bottom line. So we're pretty encouraged as the manager of a smaller-company fund. We're starting to see modest outperformance after six or seven years of significant underperformance, when the large caps really led the market indexes." The fund's top holding at the beginning of February was Coinstar Inc., which owns a nationwide network of coin-counting machines.

So where are small-caps headed? Jensen says the questions that will affect equity prices the most are ones no one can answer: How much are earnings going to recover in 2002 and what do prices look like relative to those expectations? "It's almost an economic and fundamental question as much as a valuation question," he says.

Particularly with small caps, timing the market is near impossible, says Rolf Banz, chief investment architect for Pictet Asset Management, part of Geneva-based Pictet & Cie, Switzerland's largest private bank. As a graduate student in the 1970s, Banz authored a seminal academic work that demonstrated the alleged superiority of small stocks.

"With small caps, when you look at past performance, the good performance tends to come in short, sharp bursts, and of course, the problem with that is it's very difficult to capture the beginning of short, sharp bursts," Banz says. "People who try to time the market will give up and not invest. People who feel small caps make sense for their allocation need to consider the long term and be willing to live with volatility if they want to get the experience on average."

Banz says investor confidence plays a major role in affecting small-cap performance because when there is uncertainty, there tends to be a flight to quality. And he does think quite a bit of economic uncertainty remains, although he believes U.S. markets will improve earlier this year and Europe will follow. "I think this year, one would expect us to come out faster," he says. "One thing that worries me is the market seems to have discounted a rather steep recovery, and we're not so sure that's going to happen."