Small, medium or large? These are your usual choices for your takeout coffee — and for your stock portfolio, as well.

In Canada, large-capitalization stocks have been the best choice for portfolios for the past two years, as large-cap stocks have performed the best. Elsewhere in the world, however, small-cap has generally been the most profitable serving size.

Dominance of large-company stocks in Canada while small-cap stocks lead in the rest of the world can be explained by our market’s structure. Financial and resources companies dominate the Canadian scene, and both sectors have boomed since 2002. The best financial and resources stocks have mainly been large- and mid-cap companies.

Market-leading gains by small-cap stocks are a phenomenon of bull markets. But in bear markets, small-caps usually lead on the downside — meaning, their bull market gains reflect the “high risk, high reward” axiom.

Your view on whether to emphasize small- or large-cap stocks in portfolios this year will be tempered by your view of the business outlook: if you expect a slowdown or recession, history shows large-cap stocks are stronger buffers; whereas, small-cap stocks will be hammered if the stock market drops.

If your bullishness is correct in 2007, small-cap stocks in Canada hold out the promise of better returns than they have provided in the recent past. Certainly, the earnings outlook for small-cap stocks in Canada appears stronger than for large-caps.

For the largest stocks in the S&P/TSX small-cap index, consensus estimates of earnings gains this year range as high as 29% for Gildan Activewear Inc., 14% for Alimentation Couche-Tard Inc., 19% for First Quantum Minerals Ltd. and 13% for Inmet Mining Corp.

For the largest stocks in the S&P/TSX 60 index (large-cap stocks), gains in consensus earnings estimates are mainly in the single digits for the dominant banks, but 14% for Manulife Financial Corp.

Power Corp. and its affiliates dominate the largest stocks in the mid-cap index; and their estimated earnings gains are mainly in the low teens. Within this group, SNC-Lavalin Inc.’s estimated earnings gain of 16% stands out.

These estimates exclude income trusts and energy stocks — for which cash-flow estimates are available. Income trusts have been included in S&P/TSX indices since December 2005, resulting in a jump in earnings and dividends for the indices.

Should Canadian small-cap stocks perform strongly this year, it would bring the Canadian market in line with the more recent global experience. Measured worldwide, small-cap stocks gained 22.3% in 2006, vs a 19.3% rise in large-cap stocks. In between were mid-cap stocks, up 20.6%, according to the FTSE world index.

In Canada, the S&P/TSX 60 index gained 17% last year, while the S&P/TSX mid-cap and small-cap indices gained 10.5% and 6.7%, respectively.

SMALL-CAPS LEAD IN U.S.

Canada’s small-cap stocks began underperforming other sectors in 2003, and mid-caps followed in mid-2005. This is quite a contrast to Wall Street. Since stock markets started rallying in 2002, small-cap stocks have led on Wall Street.

The Russell 2000 index — widely followed as a U.S. small-cap benchmark — has gained 104% since yearend 2002. The Russell 1000 index, which measures large-cap stocks, has gained 62%. The results are the same when measured with Standard & Poor’s Corp.’s index system.

In Canada, though, the story has been different. Since yearend 2002, the S&P/TSX 60 index has gained 100% and the small-cap index only 64%.

Where the four-year pattern varies in Canada is with mid-cap stocks: this index has risen 102% since 2002 vs 88% in the U.S.

Four-year gains in earnings underline relative price movements. Canadian large-cap index earnings have increased almost 500% since yearend 2002; mid-cap earnings are up almost threefold. Earnings on small-cap stocks have barely doubled since yearend 2003. (The index showed a loss in 2002.)

As of yearend 2006, earnings on the S&P/TSX 60 index were 59% higher than a year prior. Mid-cap index earnings were up 6% and small-caps up 12.5%. Over the past three years, the trend has been toward larger earnings increases in large-cap earnings and smaller increases for the mid- and small-cap indices.

With income trusts excluded, equity-only mid-cap index earnings gained 5% last year and equity-only small-cap earnings gained 9%.

There will be a better measure of small-cap stock performance in March, when S&P and the Toronto Stock Exchange introduce a new, managed small-cap index. It will be independent of the composite index system, but will continue the existing S&P/TSX small-cap index numbers.

@page_break@Stocks selected for this new index must have both capitalization and float of at least $100 million but no more than $1.5 billion. As the prototype stands, the new small-cap index includes 240 companies. IE