Aug. 21 (Bloomberg) -- Investors have said for months that shares of the largest companies would start outperforming so- called small-cap stocks, reversing a seven-year trend. It's finally happening, and the gains may be just beginning.

Around the world, companies such as Pfizer Inc. in the U.S. and Iberdrola SA of Spain have become cheaper relative to earnings or dividends than are small companies. Many also have lower debt, making them less risky at a time when earnings growth may slow along with the global economy. Bigger companies also have higher returns on equity, said Rupert Della-Porta, head of U.S. equities at F&C Asset Management Plc in London.

Morgan Stanley Capital International's World Index, which tracks companies with a median market value of $11 billion, has gained 7.6 percent this year in dollar terms. The firm's World Small Cap Index of companies with a median value of $460 million has risen 4.8 percent. Since markets peaked May 9, the performance gap has been even wider, with large-company stocks falling 3.7 percent and small-caps losing 11.1 percent.

``The outlook for the market is questionable,'' said Della- Porta, who manages $4 billion. ``Large-cap returns on equity are pretty good. Historically they are reasonably inexpensive relative to the rest of the market and large-cap companies are better diversified.''

He's been buying Pfizer, the world's largest drugmaker, and Citigroup Inc., the biggest U.S. bank. The companies, both based in New York, have market values of $197 billion and $240 billion, respectively. Della-Porta sold mining-equipment maker Joy Global Inc. and Harman International Industries Inc., which produces audio systems for cars. The companies have respective market capitalizations of $5 billion and $5.7 billion.

Seven-Year Run

Based on the MSCI indexes, small-company shares globally have fared better than large caps for each of the past seven years.

The biggest 50 to 100 global companies by market value have significantly underperformed during the past five to six years, said Simeon Hyman, a strategist in the private investment- management unit of Lehman Brothers Holdings Inc. in New York.

He recommends that investors consider buying a basket of ``mega-cap'' stocks such as an exchange-traded fund. Among them is the Dow Jones Global Titans Index, which includes the 50 largest multinational corporations.

Investors and analysts say several statistical measures support the case for further gains in larger companies' shares.

Price, Earnings

In the U.S., the Standard & Poor's 500 Index had a higher price-earnings ratio than the Russell 2000 Index, a benchmark for U.S. small-company shares, for about five and a half years. That reversed in July 2003 and large caps have become steadily cheaper since then, according to Birinyi Associates Inc., a Westport, Connecticut, research and money management firm. The same general trend occurred in Europe, according to Goldman Sachs Group Inc.

Companies in the S&P 500, with a median market value of $12.3 billion, sell for 17.2 times earnings for the past year. Russell 2000 companies, with a median value of $581 million, are priced at 31.2 times profit, according to data compiled by Bloomberg.

In Europe, the Dow Jones Stoxx Large Cap Index has a PE ratio of 14.3, versus 21.1 for the Dow Jones Stoxx Small Cap Index. What's more, the average dividend yield for the biggest European companies, at 3.3 percent, is higher than that of European small-cap stocks, which currently yield an average of 2.4 percent.

Lower Debt

In the six and 12 months after May 1994 -- the last time European large-caps were this cheap relative to small caps -- shares of the larger companies rose 9 percent and 17 percent, respectively, more than small-caps, according to Sharon Bell, a strategist at Goldman in London.

In Asia, companies in MSCI's Asia Pacific Index fetch 17.8 times this year's estimated earnings, while the Pacific Small Cap Index has a PE of 20.1.

On the balance-sheet front, Europe's largest companies have reduced their average net debt to 45 percent of equity, from 86 percent in 2002, according to Bell. Small companies haven't been so disciplined: Four years ago, their debt-to-equity ratio was 81 percent; today it's still 67 percent.

In the U.S., the 100 biggest U.S. companies sport a 22 percent return on equity, Della-Porta said, citing statistics from Empirical Research Partners LLC. The smallest 2,000 have a 10 percent return on equity, which measures how much profit a company generates relative to shareholders' equity.

Investor Sentiment

Investors say the outperformance by large caps will persist, two recent surveys show. Eighty-five percent of 209 fund managers overseeing a combined $637 billion surveyed this month by Merrill Lynch & Co. predicted that large-cap stocks would outperform small-caps in the next 12 months. In a mid-July poll by Goldman, 74 percent of respondents said large caps would fare better.

Loading up on large-cap stocks may leave investors with too much in a handful of industries, according to Christine Baalham, who manages $940 million at Investec Asset Management Ltd. in London. For example, oil, bank and health-care stocks account for more than half of the U.K.'s FTSE-100 Index, yet only 6 percent of U.K. small- and mid-cap indexes. And because these sectors are more international, they would be hurt by a falling dollar.

``Buying large caps isn't by itself necessarily a successful strategy,'' said Baalham. ``Stock-picking remains important.''

In Europe, Goldman has assembled a list of 10 companies with market values of more than 20 billion euros ($25.6 billion) that its analysts rate a ``buy.'' It includes Bilbao, Spain-based Iberdrola, a power company, and Royal Philips Electronics NV of the Netherlands, Europe's biggest consumer-electronics maker.

Bursting Bubble

The small-cap bonanza had its roots in the bursting of the technology bubble in 2000, when large technology companies such as Intel Corp. and Cisco Systems Inc. began to fall out of favor. At the time, the price-earnings ratios of large-cap stocks in the U.S. stood at a 30 percent premium to small caps, said Lehman's Hyman.

More recently, small- and mid-cap stocks have been the beneficiaries of a relatively benign economic backdrop and increased numbers of mergers and acquisitions, in which they became bid targets.

Smaller companies ``tend to be more cyclical in nature and, therefore, tend to outperform when growth is accelerating,'' said Ian Richards, an equity strategist at ABN Amro Holding NV in London.

Now, however, the shoe is on the other foot. Central banks around the world have raised interest rates, prompting speculation that earnings and economic growth will slow. Investors as a result are looking for less risky investments.

``Investors tend to move into large caps when they become more risk-averse,'' said Bell at Goldman.

To contact the reporter on this story: Michael Sesit in Paris at msesit@bloomberg.net

Last Updated: August 20, 2006 19:11 EDT