Small Caps Overvalued? Actually, Just the Opposite!

There’s a lot of chatter in the media right now about the valuations of small cap stocks, and why not? They’ve surged 14% since the election, as measured by the Russell 2000 Index. So it’s easy to pick one of the best performing asset classes and try and poke holes in it.

But I personally think the stock market has more room to run. And if you’re going to buy stocks, what makes more sense: Buying those indices and stocks that have lagged, or those that have excelled? I think you ride the biggest winners, which in this case, are small caps.

Since the election, the Dow Jones Industrial Average (30 ultra-large bellwether companies) is up 9%, while the S&P 500 (a larger group of large cap companies) is up 6.5%. But considering the Russell is up 14% in the same timeframe, those indices have been the clear laggards.

The reason for the large variance between small and large cap stocks is their focus. Large cap stocks do over 30% of their business abroad, while the small caps are much more domestically focused. They’re also the biggest beneficiaries of domestic growth and the expected policies of our new administration, coupled with a Republican-controlled Congress.

No wonder the National Federation of Independent Business just said its small business optimism index soared more than 7 points in December, the biggest increase in any month going all the way back to 1980.

Meanwhile, the Federal Reserve is raising interest rates, and this economy is ready for it. Job creation is excellent, wages are higher, and other forward-looking indicators are flashing positive signs across the U.S.

Higher rates also make our dollar more attractive as a yield currency in a world of negative and ultra-low rates. That’s a headwind for companies that export their goods abroad because it makes them more expensive for foreign buyers. But that’s mostly a headwind for the larger cap stocks, not domestically focused, small cap companies. And that’s why the performance bias, especially since the election, has been toward small cap stocks.

Indeed, after treading water or underperforming since 2014, the small caps have started to leave the rest of the market behind.

So the question is, has the rally gotten ahead of itself in the last two months, pricing in everything positive that’s to be had?

The answer, if you consider valuations, is NO.

Look at this chart of the price-to-earnings ratios for the Russell 2000 and the S&P 500 Index. The same pattern is apparent when it comes to price-to-sales or price-to-book ratios, and EBITDA valuations.

The first thing you’ll notice is that the Russell P/E fell below the S&P 500 P/E in 2012, before playing catch up at the end of 2013 when the “risk on” investing mentality helped the smaller cap stocks capture P/E multiple expansion.

But then, as the bond bubble inflated dramatically, ultra-low yields prompted purchase of bond-like stocks – utilities, telecoms and REITs that paid high, stable yields. Small caps were again left in the dust, for over two years, so they still look plenty cheap on a relative basis.

Two of my favorite small cap sectors include energy and financials. If you look at trailing P/E ratios for small cap energy stocks, you’ll see they’re still not as high as they were in 2014 before the collapse of the oil sector.

Now, with oil improving in price on OPEC cuts and expectations for a more balanced supply and demand picture, earnings in the sector are again expected to be positive. And let’s not forget financials, which comprise about 20% of the Russell 2000. The steepening yield curve, and lower regulatory hurdles, could finally allow those stocks to take off to the upside as well.

Bottom line: We have a healthy economy, and in this later stage of the bull market run, there’s a healthy dispersion out there within asset classes and sectors. Don’t let point-in-time comments on valuations scare you. Instead, if you take a more holistic view that includes a rational analysis of historical valuations, you’ll see that any pull back in small caps would be a great buying opportunity.

Pretty soon, I’ll show you exactly how you can profit. So stay tuned!

Best,

Mandeep

Small Cap Edition, By Mandeep Rai, Senior Analyst Mandeep Rai has more than 15 years of investing experience, working as both a stock and credit analyst. At Weiss Ratings, he researches and evaluates financial and economic themes, and makes decisions on when to buy or sell specific shares for the Top Stocks Under $10 portfolio.