When it comes to buying undervalued stocks, size doesn’t usually matter to Joe Huber. The CEO and head portfolio manager of Huber Capital Management recently achieved a rare double when both his large- and small-company funds beat out all of their respective peers to win 2014 Lipper awards for five-year performance. In a raging bull market, his Huber Capital Small Cap Value Fund stood out by returning an average of 34% annually through the end of 2013, vs. 20% for the small-cap benchmark Russell 2000 index over the same period.
As assets flooded into his small-cap portfolio last year, however, Huber made the hard decision to close certain share classes to new investors and return some money to clients. Why? In part because, with the portfolio nearing $1 billion, he felt it was getting unwieldy. But it was also becoming too tough to find good values. For the first time in his two-decade career, he says, small-cap stocks appear noticeably more expensive than their larger peers.
“You wish the opportunities were still there, but unfortunately they’re less than they used to be,” says Huber. So he’s increasing his focus on big companies. In fact, he recently launched a new fund targeting Fortune 500-size corporations. Says Huber: “There are just a lot more opportunities in large-caps right now.”
It’s a dilemma shared by many investors who are used to identifying hidden treasures in the ranks of smaller companies. Since the beginning of 2000, small-caps have returned 10.3% a year on average, vs. just 3.7% for large-caps, according to data from Ibbotson Associates. And investors have, inevitably, flocked to that outperformance. Last year, assets in small-cap funds passed $575 billion — the highest level ever. “The market’s been so picked over that a lot of the things that look inexpensive deserve to be,” laments Jay Kaplan, who helps manage $39 billion in assets at Royce Funds, which has specialized in small-caps for more than 40 years.
Indeed, the stocks in the Russell 2000 currently trade at an average of 69 times earnings, compared with a price/earnings ratio of 17 for the S&P 500. “I think that small-cap stocks are probably in a bubble,” says Jack Ablin, chief investment officer of BMO Private Bank, which manages some $66 billion. “The valuations are just a rock around their neck.” BMO has slashed its exposure to small-caps by more than half, to just 4%, and moved 56% of its assets into large-market-cap stocks, up from 36%.
It’s a common belief that small-company stocks deliver higher returns than large-caps over the long haul. And it’s true — to an extent. Since 1926, small-cap stocks have outperformed their larger rivals by an average of about two percentage points annually, according to Ibbotson. But they can also underperform for long periods, and often do. From 1985 through 1999, for example, large-cap returns were on average five percentage points higher than those of small-caps. Many market observers believe that small-cap aficionados should brace themselves for another such period of lagging returns. “Long-term, the relative performance is there, but this cycle may be coming to a close,” says Steve Wood, chief market strategist at Russell Investments. “Rebalancing makes sense.”
The reasons for the historical streakiness of large vs. small outperformance are varied and difficult to nail down. For instance, market experts say that large-caps have been penalized in recent years for their perceived exposure to emerging markets, while small-caps have appealed to investors’ appetite for homegrown businesses benefiting from the American recovery and exciting new tech stories. It’s hard to predict the point at which momentum will shift.
But the fact that the current bull market is growing long in the tooth is another argument for moving out of small stocks now. Large-caps are perceived as relatively safer and more stable. And in the event of a market correction, large-caps should fare better, says Ablin. “When stocks start to drop, investors are going to want to sink their teeth into something tangible,” he says. As a broad way to play large-caps, Ablin recommends the iShares S&P 500 Value ETF, which tracks roughly 340 stocks.
Bargain hunters such as Huber are finding value buys in stalwart businesses that have fallen out of vogue. For example, Huber recently expanded his positions in offshore driller Ensco, which trades at just eight times earnings, and in Voya Financial, the former U.S. arm of ING that was recently spun off from the Dutch conglomerate. It’s a similar story at the $21 billion Oakmark Equity & Income Fund, which invests in companies of all sizes. Co-manager Colin Hudson says the Oakmark team has been selling small- and midcap stocks and buying big ones. Right now he likes oil-services provider National Oilwell Varco and software giant Oracle, both of which trade at a discount to the market.
The move to large-caps appears to be a boon for Rich Rosen, lead portfolio manager of Columbia Select Large-Cap Value, one of the top-performing mutual funds in its category over the past decade. Rosen is bullish on brand-name stocks in his portfolio, such as Verizon Communications and Altria Group. However, like Huber, Rosen also manages small-cap portfolios. And while the balance may be swinging from small to large, he says, the best advice for most investors is to get exposure to stocks across the spectrum and stay put. “We don’t want to miss the upside for being too focused on the downside,” he says. Plus, if history is any guide, small stocks will eventually make up any lost ground.
This story is from the April 28, 2014 issue of Fortune.