In the past two years, as the world economy has worked to shake off the doldrums of global economic crisis, investors willing to take big risks coming out of the slump have won handsome rewards in many investment categories.

"The stocks that in general performed the best over the last year and three-quarters have been companies that you think perhaps are riskier," says Bob Wyckoff, a partner/owner at asset management firm Tweedy Browne.

Financial companies, for instance, had a tremendous bounce from their bottom in 2009. So did media stocks. Small caps outperformed large caps. Emerging markets performed better than their developed market brethren. Leveraged businesses did better than unleveraged ones, he says.

But if people have been rewarded for higher risk-taking in the last couple of years, jumping into growth off a bounce, might they be rewarded for seeking value in the years ahead?

It's hard to say exactly what will happen next. People already thought small caps were primed for a downturn last year, so high their valuations had risen. So it's understandable people still think that small caps and mid-caps, which have outperformed in the last couple of years, may now have to take a back seat to large-cap blue chip stocks, which everybody roundly believes are very cheap. Others say that emerging markets, which have been hogging the spotlight, have left in the shadows a lot of sweet developed market bargains.

Large-Cap Comeback?
Many blue chip stocks continue to be unfairly priced for slumps even as their earnings increase. Bill Miller, the CIO of Legg Mason, said in the Financial Times in September that large-cap stocks were the bargains of a lifetime and hadn't been this cheap next to bonds since 1951.

Some quality large-cap companies sell for less than 14 or 15 times trailing earnings, cheaper than they have been since the financial crisis and before that in over a decade, says Adriana Posada, a co-manager of the American Beacon Large Cap Value Fund, a four-star portfolio with Morningstar. Posada agrees with Miller that the outlook for large-caps is indeed good.

In 2010, the underperformance of large caps was more than 10% relative to small caps as measured by the Russell indices, she says. The problem is that when large caps suffered their lost decade, many investors turned away from them, fleeing to quality in Treasurys perhaps, and large company valuations plummeted. That has now made them cheap, attractive buys.

And yet, in the meantime, Posada says, "many multinationals have improved their businesses and continued operating successfully during the recent recession, continued to grow, increased earnings and many have been paying a dividend yield above Treasurys and investment-grade debt yields." They've increased their dividends to boot, she says. And large-cap investors will further benefit as the economy picks up.

Michael R. Keller, portfolio manager of the BBH Core Select Fund at Brown Brothers Harriman & Co. Investment Management, says: "It is indeed the case from what we've seen that large cap looks cheaper than small cap at this point. But in our view, it always has to be filtered through where the growth opportunities are in those areas, where is your capital going to be protected, where are you going to have greater visibility into the quality of the businesses over a long period of time? And for our purposes, large-cap quality companies tend to fit more along those lines where we have a greater visibility into the 10- to 15-year type of outlook."

That's led his fund to purchase companies with recurring, easy-to-see sources of revenue-the usual suspects are value plays such as consumer goods companies Diageo and Nestle, big box stores Walmart and Costco and famous value play Berkshire Hathaway.

Small Caps
It's an investor axiom that smaller, riskier companies with severely bludgeoned valuations are the ones that usually lead a market recovery, and that's been no less true in the past couple years, when small-cap stocks trounced their large compeers. In 2010, the S&P 600 small-cap index rose 26.31% while the large-cap S&P 500 rose only a squeak above 15%.

Though it might seem as if small-cap and mid-cap stocks have run their course, and that their valuations are getting too high, Quincy Krosby, an economist at Prudential Financial, says that perhaps there's still a reason to like them. As the economy continues to improve, she says, there will be more mergers and acquisition activity in this space, especially now that larger companies are sitting on record levels of balance sheet cash and will likely go on buying sprees for small fry. Small-cap and mid-cap stocks will be the prime targets of mergers and private equity buyouts, and these dynamics could further goose their company returns.

She stresses that even though small-cap valuations are high, these stocks should remain part of a balanced portfolio.

Paul Magnuson, a co-portfolio manager of the Allianz NFJ Small Cap Value Fund, a five-star fund at Morningstar, and one of Morningstar's nominees for stock manager of the year in 2010, says the increasing volatility of the stock market in the past decade has been one of the all-important considerations for stock performance, which is why his fund is concerned with those names that pay dividends.

"No matter what period you test ... dividend-paying stocks have considerably less volatility than non-dividend-paying stocks. We just think it's a better fishing pond, and in the current environment it's a much better fishing pond."

He says dividend-paying stocks also perform well in inflationary environments. "The reason is that in an inflationary environment, long-duration assets get hurt the most and people just want to get a portion of their total return sooner as opposed to later."

Mid Caps
Andrew C. Stephens is the portfolio manager of the Artisan Mid Cap Fund (ARTMX) and was another nominee for fund manager of the year by Morningstar. Stephens is a growth manager, and says that when there is growth in the economy with modest inflation, the environment has been positive for stocks. When inflation is moderate, price multiples generally go up.

"As growth investors, we think of our job as finding growth where it occurs," says Stephens. "Our preference is for that growth to be organic growth, meaning profit growth that is not dependent on a strong macro recovery.

"A year ago, we thought the case for owning organic growth in a moderate growth environment was very compelling," he continues. "Particularly those companies exposed to secular growth drivers such as mobile connectivity and industrial efficiency. We think these types of companies will continue to do well as we look forward, but we also think we're at a point in the economic cycle where there's some momentum to the recovery. As a result, we're a bit more comfortable increasing our exposure to cyclical growth."

Andrew Braun, co-manager of the Goldman Sachs Mid Cap Value Fund, says he's finding many new investment opportunities in the small and mid-cap space as revenue growth resumes and margins keep expanding.

"That said," Braun adds, "It looks like mid/small caps are approximately 3 multiple points more expensive than large-caps on a p/e basis."

International Stocks
Talk in the international stock area has been dominated by emerging markets, which have also outperformed their developed market counterparts in the past few years. Advocates of this space give credit to the increased wages, disciplined fiscal policies and favorable demographics of these developing countries, which are seeing high single-digit GDP growth. Meanwhile, countries in Europe are struggling with debt crises and threads of deflationary spirals, and GDP has grown anemic, as it has in the United States.

But some managers think emerging markets aren't the whole story.

Brent Lynn the manager of the Janus Overseas Fund, and Morningstar's international stock fund manager for the year for 2010, said in a video interview on the site that although emerging markets performed well in 2010, some countries like China and Brazil did only moderately well, and that his portfolio's outperformance was also due to some developed market holdings, including some airlines and global financial companies in Europe. There are furthermore worries that China's efforts to tamp down its own inflation will cause a chill in the emerging market countries, so important has this sleeping tiger become to the world economy.

The managers of the Tweedy Browne Global Value fund (among the Morningstar nominees for international stock pickers of the year) are famous for their adherence to Benjamin Graham-style value investing. Wyckoff and co-managers Tom Shrager, William Browne and John Spears say there are many ways to play this emerging market growth by using the company's patented approach of seeking visible, recurring revenue streams in the multinational pond of companies selling at deep discounts to their intrinsic value. Wyckoff says there have been tremendous opportunities to find such names since the fall of '08.

Wyckoff says: "The first two-thirds of [2010] were pretty volatile. It started out in the first quarter with a pretty good market and then in the second quarter things fell apart as Greece began to have its problems. We finished the year fairly well.

"I think it's fair to say during the crisis we had the opportunity to buy a number of better-quality businesses. A lot of businesses you see in our portfolio today both on the international side and on the domestic side are large, globally diversified companies that sell the kinds of products that an aspiring middle class would like to have. And we have a growing global middle class around the world, and we have terribly significant growth in that area in some of the emerging markets, and a lot of these companies in our portfolio today, the Nestlés, the Diageos, the Heinekens, the KONEs, Novartis, Emerson Electric-these are companies that do business all over the world. Many of them are domiciled in Western Europe but do a significant amount of business in the emerging markets."

With this style, it all depends on the name. Would you want to own a Chinese company selling 90% to the U.S. with a high P/E ratio, they ask, or would you rather be with a company selling to the growing middle class in China, even if it had its headquarters in Switzerland?

A very different kind of international fund manager, though one who's been highly successful in the past couple of years, is Malcolm Gissen. He and Marshall Berol co-manage the Encompass Fund, a San Francisco-based go-anywhere international stock portfolio. Gissen says his fund was rated No. 1 in the one- and three-year periods by Morningstar, and that he won a 60% return in 2010 and a whopping 137% in 2009, mainly by scouring the globe for energy, metals and health-care plays. He even managed the huge 2009 return while sitting on 30% cash, he says. Part of the success, he says, is due to the huge demand for commodities and the supply constraints that will come about because of it.

"We continue to believe that the commodity companies, the resource companies, will outperform. We continue to emphasize them in the portfolio. We also like the health-care sector and have a number of interesting companies in the health-care field. And then we're deep value investors."

Gissen says that his plays are based in part on the continuing concern investors have about holding dollar- or currency-denominated resources as opposed to hard assets. That has driven people all over the world to hold gold, silver, platinum, palladium and other metals, he says.

"What the media doesn't spend enough time focusing on is supply," he says. "We visit a lot of the companies' operations. And it's clear to us that finding, exploring, getting permitted and getting into production in order to produce commodities is increasingly expensive, is increasingly politically risky and takes increasing amounts of money. And therefore, in order to produce the copper, tin, lead, molybdenum, coal, uranium that the world demands-and that demand is increasing-it gets increasingly risky, difficult and expensive. That portion of the equation does not get a lot of attention. How difficult it actually is to produce the commodities that the world demands."  

With great success here, however, comes great risk, says Morningstar. Part of that 137% increase in 2009 was attributable to the fund's bounce back from a wretched 2008, when it lost 62%.

"That was largely because even though our companies were performing well, everything was being sold, particularly by the hedge funds, especially the commodity companies in which the hedge funds had large gains," says Gissen. "They were the first companies to be sold and there was wholesale dumping."

Real Estate
The REIT category has been on a furious tear, rising 27% in 2010 after seeing similar gains the year before, says Andrew Gogerty, an analyst at Morningstar. This is very different from the story two years ago when real estate was one of the sectors that was pounded the hardest and investors anticipated a crisis in the commercial space.

Property values had plummeted. There was a lot of leverage on REIT balance sheets, and many managers lost the access to capital that would help them buy new properties. As financing dried up, many REITs had to cut their all-important dividends (some 70% of Morningstar's real estate managers resorted to this). But those REIT managers that were disciplined found lots of discounted property to buy. And dividend payouts have increased. That's led to a sharp rise in the real estate fund sector returns.

"I don't think you're going to see the skyrocketing in rents or occupancy levels that you saw leading up to the '07 or '08 crash," says Gogerty about the outlook for the category. "You still have a lot of commercial real estate debt out there that needs to be refinanced. You're not seeing a tremendous amount of transaction volume because there's still an enormous gap between buyers and sellers."

Joseph Pavnica, manager of the Aston/Fortis Real Estate Fund, says that property operating fundamentals have started to improve, and he expects REITs cash earnings growth of about 9.5%. He says it will help fundamentals that there is not any new meaningful real estate supply coming onto the market. The improving economy will help.

"As a healthier GDP and employment picture unfolds," he says, "tenant demand increases across all property sectors."