23 May 2018

Why Small-Cap Stocks Still Look Pricey

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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.

Click here to access the full article on The Wall Street Journal. 

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