After this past week’s wild market gyrations, many investors
are worried about a looming correction. A correction is usually defined as a
drop of 10% or more, and the Russell 2000, an index of small-company stocks, is
down 12.8% since its July 1 peak. By comparison, the widely followed S&P
500, a collection of large U.S. companies, is down less than 3% since then, and
it hit an all-time high in late September.
Two hundred eighteen of the Russell 2000’s stocks, which
have an average market capitalization of about $700 million, have lost more
than a third of their value since July 1, according to data from S&P
Capital IQ.
Over a longer period, in fact, small-cap stocks have enjoyed
a strong run. The Russell 2000 surged 163% from January 2000 through Oct. 10,
including dividends. The S&P 500 returned just 75% during the same period. Even
with the recent correction, that boom has left small caps with sky-high
valuations.
As of Sept. 30, for example, stocks in the Russell 2000
traded at 1.5 times their revenue of the previous 12 months, a measure known as
the price/sales ratio. That is just a hair below the highest valuation seen
going back to 1994, the earliest year for which data is available. Such levels
were last seen during the stock bubble of the late 1990s, according to Russell
Indexes.
Stocks in the Russell 2000 currently trade at 17 times their
estimated earnings for the next 12 months, after smoothing out distortions caused
by unprofitable companies. At those valuations, small caps have historically
returned 6% over the following year, versus a long-term average of more than
11%.
Small caps have historically offered a higher return than
their larger peers. From 1926 through 2012, the smallest fifth of stocks
returned 11.5% a year, including dividends, versus 9.7% a year for the largest
fifth, according to University of Pennsylvania economist Jeremy Siegel.
But the massive small-cap outperformance in recent years
makes some investors wonder whether opportunity now favors larger,
more-established companies that trade at cheaper valuations. The S&P 500
currently trades at 14.5 times estimates of earnings over the next 12 months,
according to Standard & Poor’s.
Not everyone is as bearish. Gordon Johnson, managing
director and senior portfolio manager at Cleveland-based PNC Capital Advisors,
which manages $38 billion, says even if small caps as a whole look expensive,
there are opportunities.
Small caps tend to do less overseas business than large-cap
companies, many of which are multinationals. As the U.S. economy expands while
Europe lags behind, that is a plus for small caps.
Small caps can be highly volatile with uncertain futures, so
buying a basket of stocks is typically the safest route. An efficient way to
stay in small caps while avoiding the priciest parts of market is an
exchange-traded fund. The Vanguard Small-Cap Value ETF invests in more
than 800 small companies with below-average valuations. It charges an annual
expense ratio of 0.24%, or $24 per $10,000 invested.
Regardless of your view of small-cap valuations, the
willingness to withstand volatility is vital to long-term investing success.
One of the surest ways to guarantee disappointing investment results is to get
scared out of stocks after a big decline, only to regain your confidence after
they rebound. And ultimately, one reason small-cap stocks have historically
performed better than larger companies is because they are more volatile. That
will likely continue. Bullish or bearish, both sides agree: expect a wild ride.
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