The small-cap story remains compelling
Four months ago, I made the case that small-cap stocks were at a point at which they may begin to outperform large caps. Then the broad-based risk-off trade hit, driving risk asset prices down across the board. So where does that leave us today? Pretty much where we were in mid-October, with small caps potentially offering more upside than their larger brethren for much the same reasons: mean reversion, valuations and the macro environment. Let’s take a look at each:
- Mean reversion. With the end-of-the-year sell-off further widening large-caps’ outperformance versus small-caps—9.1% vs. 7.4% annualized, respectively, for the 5-year period ended Dec. 31, 2018, and 13.3% vs. 12.0% for the 10-year period, as represented by the large-cap Russell 1000 Index and the small-cap Russell 2000 Index—small caps arguably are in a better position to offer potentially better opportunities going forward. The reason is simply a matter of math. While nobody knows whether small or large caps will fare better one calendar year to the next, historical research suggests after prolonged periods of outperformance by one group over the other, the laggard has tended to close the gap. History also shows that over longer periods of time, small caps have tended to outpace large caps because they are by definition riskier, and risk and returns tend to be commensurate over time. And it doesn’t necessarily take years to realize better relative returns. To the contrary, small caps outperformed in 10 of the last 19 calendar years, based on the aforementioned indexes, by an average 7.8%.
- Valuations The 15-year average P/E ratio for small caps relative to large caps was 1.12 as of the end of December. Why does the long-term P/E run higher? Because investors typically are willing to pay more for small caps because they offer more growth potential (a smart idea can quickly transform into something big) and more risk (without the resources of large company, a stumble can wipe out an entire company). But at the end of 2018, the small-cap P/E ratio stood at 0.95, meaning small caps were trading at roughly a 16% discount to large caps, according to Morningstar Direct. (The comparisons were based on the S&P SmallCap 600 Index and the S&P 500 Index rather than the broader Russell indexes because Standard and Poor’s requires four quarters of profitability for a company to be included in their indexes, making P/E ratios more straightforward.) Historically, small caps have outperformed large caps by an average 8.6% over the next 12 months when trading at a discount of 10% or greater to large caps.
- Favorable domestic environment Despite mounting signs of slowing global growth, the data to date suggest the U.S. economy should continue to grow, albeit at a somewhat slower pace than 2018 but at the fastest pace among developed countries, according to International Monetary Fund projections. Given concerns about slower growth elsewhere, it’s worth remembering that small caps tend to be more domestically oriented, relying less on revenue from overseas.
Bottom line We still believe long-term, risk-oriented investors may want to consider adding to their U.S. small-cap positions.