Key Questions: Is There an Opportunity in Small Caps?
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Small-capitalization (small-cap) stocks have underperformed their large-cap peers since 2019. They are now trading at the widest valuation discount relative to large caps over the past 15 years. Both when compared to their own history and to their large-cap peers, small-cap stocks are cheap. Is there an opportunity for a tactical allocation?
The concept of a small-cap return premium has been a steadfast part of the financial lexicon since the 1980s and a key-risk premium (or excess return relative to a risk-free rate of return) investors have tried to extract for decades. US small-cap equities, as defined by the S&P 600 Index, have tended to outpace the S&P 500 Index, reflecting this risk premium. However, small caps have underwhelmed more recently, with the S&P 600 trailing the large-cap market by nearly 400 basis points (annualized) over the trailing five-year period.
Before diving deeper, it should be noted that we use the S&P 600 Index as our preferred measure of US small-cap equities, while others cite the Russell 2000 Index. We prefer the S&P 600 Index because of the higher quality of the underlying constituents. More specifically, the Russell 2000 Index has a higher percentage of non-earning companies. However, the choice of the underlying index does not change our conclusion: US small-cap equities have underperformed, and they are cheap!
Lay of the Land – Small Caps Tend to Be More Domestic
Part of the performance and valuation gap between small- and large-cap equities is because of sector composition. Large-cap indices like the S&P 500 are heavily weighted toward technology stocks, which were the main market beneficiaries coming out of the COVID crash in March 2020. Conversely, the S&P 600 sector allocation has larger exposures to cyclical stocks, such as financials and industrials. As such, small-cap indices tend to be more closely tied to the domestic economy, especially since many companies in the S&P 500 derive their revenues from international markets. This makes small-cap stocks more dependent on the US business cycle.
On a Relative and Absolute Basis, Small-Cap Valuations Are Attractive
Small-cap valuations are compelling with the S&P 600 trading at a significant discount relative to the S&P 500. You can see this when comparing forward price-to-earnings (P/E) ratios, which incorporate analyst earnings expectations for the next four quarters and are useful valuation metrics given the forward-looking nature of markets. Additionally, historical analysis of fundamental metrics such as a P/E ratio can help identify extreme dislocations within markets that may be potential catalysts for a reversal in the future.
Through June, small caps were trading at a 27% discount relative to large caps. This is in stark contrast to the nearly 18% average premium that they have traded at over the past 15 years. Relative to large caps, small-cap stocks rarely have been cheaper.
US Small-Cap Valuation
This is a graph showing the rise and fall of Small-Cap Percentage of discount, and Small-Cap forward P/E. The chart begins with the year 2007 and ends in the year 2021.
Small-cap stocks also appear cheap when compared to their history. The 15-year average forward P/E ratio for the S&P 600 is approximately 18.9x. As of June 30, small caps were trading at 11.9x, representing a discount of more than 35%.
On a forward P/E basis, small-cap stocks are the cheapest they’ve been over the past 15 years, both in absolute terms and when compared to their large-cap peers. This puts into context their recent underperformance relative to large caps and makes a compelling case to consider a tactical allocation over the near term.
There is much more to an investment case than a discounted valuation, but meaningful capital gains often accrue to those investments that started with the least demanding valuations. We may already be there with US small-cap equities.
For more information, please contact your advisor.
About Lauren DiCola
Lauren joined KeyBank in 2022 and is a member of KeyBank Investment Center's Multi-Strategy Research team, which is responsible for identifying and analyzing investment opportunities across all asset classes, and also constructing the practice’s global investment views.
Prior to joining KeyBank, Lauren was a member of Aon’s Global Asset Allocation Team, which was responsible for steering the investment strategy and asset allocation for institutional client portfolios. She also helped establish and formalize the practice’s global house investment views. As a consultant, Lauren was responsible for articulating and providing detailed research on the outlook for the economy, financial markets, and each major asset class.
Lauren has also held consulting positions at RVK, Inc. and Willis Towers Watson, where she helped advise and oversee a number of client relationships among pension plans, endowments and foundations, sovereign wealth funds, and defined contribution plans. Lauren earned her BA degree from Loyola University Chicago and is currently based in Chicago, Illinois.