I have noticed over the last couple of weeks that some of the smaller capitalization stocks I follow seem to be significantly outperforming their much larger counterparts. On strong market days they will add a couple of percent. On down days many still seem to be able to scratch out a penny or two of gain. While the headlines are shouting about the mega-cap companies shedding thousands and tens-of-thousands of jobs, there are good, well managed small companies still doing fine in the current economic environment.

The recent results for the large cap Russell 1000 index compared to the small cap Russell 2000 index seem to back up my gut feeling. Since the year's stock market low on November 20, the Russell 1000 is up 17.7% and the small cap Russell 2000 has performed 4% better, gaining 21.7%. If we shorten the span of our look back, since the big down day on December 1, the Russell 2000 has outperformed the Russell 1000 by .4.15%. The large cap index is up 8.25%, while the small caps have gained 12.4% in less than 2 weeks.

This recent impressive bounce in the markets is either a bear market rally and the lows will be tested again in the future or the bottom in November was the market's early signal that the recession will end in the next 6 to 12 months. Do not forget that historically the stock market leads and economic recovery by a significant amount of time. Even if you believe the recession will not end for another year, the stock market could easily be making its bull market move already.

If you are comfortable with the two hypotheses that a new bull market will lead the economic recovery and that small caps will outperform large caps in the early days of this bull market, I would like you to think about some rules for picking stocks for your portfolio.

1. Stay away from companies that need to access the debt markets to continue to grow their businesses. Borrowing money will be especially difficult for smaller companies.
2. Look for companies that have a unique business model. My favorite example of this is Silver Wheaton (NYSE:SLW), which signs contracts with major silver mines to purchase their silver production for about $4/oz. then sells the silver on the spot market and pockets the spread. They do business with 6 employees and almost no overhead.
3. Look for companies whose growth engine is not affected (much!) by economic slowing. The bear market has hammered almost all stocks equally and not all companies are equal. I believe Gigamedia, Ltd. (NASD:GIGM) is this type of company, with the opportunity to sell on-line gaming to all of Asia.
4. Look for well managed companies that have strengthened themselves in these tough times and will explode their earnings when economic conditions improve. Simpson Manufacturing (NYSE:SSD) is a company that has impressed me with its response to the slowdown in its markets.

The stocks I have highlighted above are not recommendations, but example of the types of companies that I believe will do very well in the coming bull market. Picking stocks in the mid to small cap world is hard work. There is not a lot of news about many companies and there are many companies. A quick stock screen with the following criteria: Market cap: $250 million to $1 billion, P/E less than 10, quick ratio greater than 2 and 5 year revenue growth greater that 10% comes up with 60 stocks. Here are a few from the list that catch my eye, primarily due to industry: ARA, BHE, FSTR, SNHY.

The list was heavily populated with biotech, semiconductor and other tech companies. I look to pick out the ones in different industries that may meet criteria #2. If this type of investing interests you I encourage you to do your own research and find those companies that meet your criteria.

Note: of the stocks discussed here I personally hold a position in GIGM.