They are in a tight race to extend their five-year run over large caps.

    Performing like Wall Street's version of The Little Engine That Could, small-cap equities are in a neck-and-neck race to outperform the large-cap sector for the sixth straight year. A victory for small caps would indeed be a surprise to Wall Street analysts who have been predicting for at least the past two years that the small-cap engine is due to run out of steam-a view that seemed to hold true the first part of the year, when large cap blew past small cap.
    Small caps have since rallied. As of September 9, the Russell 1000 Index had a year-to-date return of 4.90%, compared to 4.86% for the Russell 2000 Index.
    Small caps seem to have more momentum, with a three-month return of 8.39% for the Russell 2000, compared with 3.41% for the Russell 1000. But many analysts still see large caps overtaking small caps, and maintain that the market is well overdue for the type of capitalization rotation that has historically injected new life into prolonged periods of market growth. They note that history also shows that escalating interest rates usually signal a slowdown for small-cap companies, which are more sensitive to the Fed's fiscal policies than are large caps.
    So the conventional wisdom on Wall Street is that even if small caps outperform in 2005, large caps are very likely to finally assert themselves in 2006 and trying to predict the precise time when this transition takes place is futile. But investors should take note of a couple of things before overhauling their portfolios.
    First, Wall Street's  "conventional wisdom" has been known to send investors to the poor house on occasion. Second, not everyone is convinced small caps are fading. "There are decades when all you want to own is large-cap stocks. I don't think this is one of them," says Mary Lisanti, manager of the Adams Harkness Small Cap Growth Fund.
    Also calling upon history, Lisanti says small caps historically had long periods of outperformance after the bull market collapses of 1929 and the 1970s. She also notes that small caps continue to significantly outperform large caps in terms of earnings growth.
    "I think it's like the 1975-to-1983 period for small caps," she says, referring to a period when small-company stocks dramatically outperformed a sideways market. "Everyone tends to divide the cycles into four or five years, but they are longer than that."
    Another illustration of the conflicting views that can be found in the small-cap versus large-cap debate can be found at Lipper Inc. While the research company forecast this year-and last year-that large caps will outperform small caps, Lipper senior analyst Andrew Clark has yet to see any evidence of a shift. "My view is that it's not going to happen," he says.
    Clark doesn't buy into the view that small- and large-cap valuations have compressed to the point where capitalization rotation is both imminent and inevitable. He also looks at the 1930s and 1970s as historical periods that closely parallel the investment environment since 2000, and as an indicator that large caps still haven't recovered from the overvaluations that led to the dotcom crash and the bear market.
    "Where stocks got really overvalued was in the large-cap arena, not in small caps," he says. "Large caps have a longer repair period and take some time to come back up."
    While small caps are sensitive to interest rates, Clark says the Fed has taken a gradual approach to raising rates, which has softened the impact on smaller companies. He also notes that the economic expansion is also atypical in terms of wage increases. "Eighty percent of the workforce is barely staying even with inflation," he says.
    Among small-cap managers, it's hard to find anyone who sees any indications of a slowdown. In fact, many managers say their screens are turning up an increased number of potential holdings. Earnings growth is robust among smaller companies, they say, adding that small growth companies seem to be gaining momentum.
    Several small-fund managers interviewed noted that they were overweight in information technology and health care-two prime growth sectors. "We're now beginning to see the growth come back in the whole capital spending area of technology," says Ed Vroom, manager of the Hallmark Small Cap Growth Fund. "It's reflected in revenues and profit forecasts that are above what people are seeing in the overall economy."
    The uptick in capital spending by technology companies this year comes after a two-year contraction in spending, he adds. "We're starting to see for the first time budgets increase at a higher rate than the year before and a higher rate than what the economy is expected to grow," Vroom says.
    Among the technology companies that fund has bought is Witness Systems, a developer of software used for the management of call centers. The company's share price has grown from $13.50 to $18.50 over the past year. Another successful purchase has been Business Objects, a developer of business intelligence software, which is priced at $36 per share, up from $20 a year ago.
    Rick Weed, manager of the Putnam Small Cap Growth Fund, says the small-cap sector was impacted in a different way than large caps after the dotcom crash. While large-cap technology companies are still coping with limited growth and inflated share prices, small caps have gone through a Darwinian-like transition that has worked to the benefit of stock pickers.
    "The small-cap growth stocks went out of business when the bubble blew up," Weed says. "Any small stocks that survived had good businesses."
    That has resulted in a small-cap technology sector that is stacked with companies that are focused and well managed, he says. Also, unlike large caps, small-cap tech companies weren't suffering from overvaluation at the time of the crash. "I think small-cap growth has more wind behind it now in terms of purely valuation."
    Small stocks also tend to do better in the current market environment, which is marked by low returns and low volatility. "It's a difficult market for people trying to choose stocks who are looking to outperform," he says. "But you can find niche players in small cap no matter what the economy is doing."
    Lisanti says an analysis of the small-cap sector since 2000 shows just how much the dotcom crash shook things up. At the beginning of that period, she says, there were 5,500 companies under $2 billion in market capitalization. Today, there are still about that same number, but the group includes 1,400 companies that were in the mid-cap sector in 2000.
    That means roughly 1,400 small-cap companies from 2000 disappeared, replaced by companies whose tumbling share prices dumped them into the small-cap arena. "What you ended up with was real structural and secular reform," she says.
    Companies built up infrastructure and restructured markets, she says. "What they've done is not a short-term fix, but a long-term fix," she says.
When Lisanti's fund screens for potential holdings, it comes up with about 700 to 800 companies. During the bear market, she says, the list was comprised of about 200 companies. "They're coming to see us like nobody's business because they know they have good stories to tell and they feel like nobody is paying attention," she says. Among the fund's best buys has been Progressive Gaming International, which develops software systems that allow casinos to track the use of their games and machines. The company brought in new management two years ago to restructure and put focus on its software operations. The company's share price is $15, up from $4.78 a year earlier.
    Noting that the Russell 2000 is experiencing average earnings growth of 25%, compared with 11% for the S&P 500, Lisanti feels the run of outperformance for small caps is far from over. "If you are a small company, life is very good," she says. "If you're big, it's not very good. You have much more competition and you probably have to worry about China a lot more than these little guys."