SMALL-CAP VALUE AND

small-cap growth stocks have been jockeying for the lead position ever since the great small-cap race began in late 2002 and so far value is winning. But now small-cap growth has suddenly started to catch up, begetting the question of whether it's time to switch horses in midstream.

It's a tough call to make, for individual investors as well as the experts. Tobias Levkovich, Citigroup's chief investment officer, makes a compelling case both for and against small-cap growth, and although he has a long-term bias in favor of growth, he sees a rocky transition ahead. So Levkovich proposes a novel solution. In a report last week, he advised clients to split the difference and bet on small-cap stocks that are considered to be both growth and value.

But first, a little recent small-cap performance history. The small-cap benchmark Russell 2000 index is up nearly 140% since October 2002, almost doubling the performance of the S&P 500, and over that time investors playing the style boxes have won by betting on value. In the interim, both the Russell 2000 Value index and the Russell 2000 Growth index have had respective periods of supremacy, but over the last four-and-a-half years, value has significantly outperformed growth, with the value index up about 140% vs. the growth index's roughly 130% gain.

The last year has seen more of the same, with value gaining more than 13% against little more than a 6% gain for growth. But the last six months have seen growth start to narrow the gap, beating their value cousins by about 1%, "and we suspect buy-side investors awaiting a handoff from value to growth will soon begin to notice," Levkovich wrote.

The case in favor of small-cap growth hinges on three factors, Levkovich says. One, their valuations appear more attractive when compared to small-cap value. Additionally, seasonality favors small-cap growth in the second half of the year. And finally, dividend yields for small-cap value remain near historical lows, casting doubts on their ability to offer investors a total-return safe haven in a slowing growth environment.

Then there's the case against small-cap growth, which includes individual investor sentiment favoring value; a dramatic narrowing of the gap between long-term earnings expectations for growth and value; and an elevated equity risk premium linked to small-cap value's stronger performance.

Levkovich doesn't anticipate a powerful surge into small-cap growth stocks at the expense of small-cap value in the coming months, but rather a long and difficult progression. And the shorter term is likely to be even more confounding.

"While our bias for small-cap growth over small-cap value over the longer term remains in place, near term, we suspect that small-cap value stocks may continue to show periods of strength in coming months as the equity market continues to come to terms with a slowdown in earnings growth," Levkovich says.

In that context, stocks that are considered to be both growth and value plays within the Russell 2000 universe look most intriguing since they may provide cover in what Citigroup anticipates will be a rocky and lengthy transition period back to small-cap growth.

Citigroup has Buy recommendations on 11 stocks with market caps below $1 billion that are components of both the Russell 2000 Growth and Russell 2000 Value indexes. Of those 11, three stocks are also rated at or are very close to Buy, on average, by all analysts polled by Thomson Financial. The winners are Williams Scotsman, of Baltimore, one of the largest suppliers of mobile offices and portable storage units; Alliance Imaging, an Anaheim, Calif.-based diagnostic imaging company; and Northstar Neuroscience, a medical-device company based in Seattle.

Williams Scotsman is a beneficiary of the pick-up in nonresidential construction, Citigroup says. Shares are off by about 15% in the last year to $20.01 as of Tuesday's close, but analysts' average price target stands at more than $27, according to Thomson Financial, making the implied upside 37%. The shares are also attractively valued compared with the broader market, boasting a forward P/E and a price-to-earnings growth (PEG) ratio at a slight discount to the S&P 500.

Alliance Imaging operates about 500 pieces of imaging equipment, such as CAT scan machines, for more than 1,000 clients. Piper Jaffray analyst Mark Arnold sees a number of potential catalysts going forward, including the release of its first-quarter earnings in May, which he expects will beat estimates, and the possible filing for bankruptcy of its largest competitor, privately-held InSight Health Services.

Alliance's shares have gained more than 70% in the last year to $9.20 as of Tuesday's close. The company's forward P/E multiple and PEG ratio trade at premiums to the broader market, but at deep discounts to the company's peers and industry. And with an average price target of $11, the shares have an implied upside of almost 20%.

Northstar Neuroscience is developing a device that delivers electrical stimulation to the brain, intended to help stroke victims regain motor function in the arms and hands. The investment thesis is that Northstar's proprietary technology will allow it to "own the cortex" and become a major player in the neurostimulation marketplace because of physician and patient demand, wrote Stephen Brozak, an analyst with WBB Securities. The absence of earnings means there's no valuation data for the stock, which has dropped more than 25% to $12 as of Tuesday's close. But analysts' average price target stands at more than $20, making the implied upside about 67%.