Who Says Small Caps Are Overvalued?

“Substantially stretched” was the term Federal Reserve Chair Janet Yellen used a few weeks back to describe the valuations of smaller-company stocks in the United States, particularly those of smaller biotech and social media firms. The performance of small caps —and their outperformance versus large caps—has been evident not only in the United States, but also in other developed markets.  For example, in local-currency terms, European small caps were up 36% in 2013, Japanese small caps were up 54%, and U.S. small caps were up 38% (per MSCI indices). Given this strong run, it’s natural to find investors questioning small-cap valuations and what they may mean for future investment opportunities in the asset class.

Important to the valuation discussion is recognizing that over time there is a persistent norm for small caps to trade at a premium to large caps on a price-to-earnings basis. Why? Investors are generally willing to pay for the higher expected earnings growth that smaller companies offer. However, expansion of the relative P/E premium in recent years may have as much of a cyclical element to it as it does fundamental since much of the outperformance by small caps is a recovery from the financial crisis (which not surprisingly hit small caps harder than large caps). That said, we view many markets as still being in the early stages of recovery; thus, we’d contend that small caps still offer upside opportunity.

Investors may also be applying a higher premium on small caps with the belief that large caps are nearing peak margins and small caps have more room for expansion with continued economic recovery (for some additional detail on these valuation points, here’s a link to a chart book; here you can check out the net-margin chart).  Furthermore, because of the higher proportion of cyclical companies and industries in the small-cap universe, more cyclical earnings patterns tend to exist. And, because there are  more “young” small-cap companies, which have yet to reach profitability, particularly in sectors like technology and biotech,  P/E ratios tend to appear inflated for small caps (see effect of removing negative earners from the data in the supplemental chart book).

Given this cyclicality of earnings, valuation multiples that are more stable over time, such as price-to-sales and price-to-book, can provide additional insight. While small caps tend to trade at a premium to large caps on a price-to-earnings basis, they tend to trade at a discount relative to large-caps when comparing price-to-book and price-to-sales. This is partly, if not primarily, attributed to their generally more cyclical profitability. Indeed, when looking at the historical ranges for both of these metric on a relative basis, these multiples are in-line with their historical averages (see chart book).

Growth, of course, is another important part of the equation. The table below shows how small- and large-cap stocks stack up against one another—showing a clear growth advantage to small caps. So, while the outperformance of small caps in recent years has unarguably narrowed the prospective valuation advantage of small caps, it certainly hasn’t eliminated it.

small cap table

Source: (FactSet, Russell, MSCI)

We continue to have strong conviction that all investors should have a strategic allocation to small-cap companies in their portfolios and despite some of the small-cap valuation opportunities diminishing over the last several years, we continue to be optimistic about the prospects for the asset class.

Our full view of small caps is very much driven by our conviction in the benefits of an active management. If viewing the small-cap opportunity set through a passive lens, it’s quite likely to yield a different perspective.  In my next post, I’ll look at exactly that issue, when I discuss the active-versus-passive debate as it relates to small-cap stocks.

To see the data that underlies and supports our position, please see our supplemental chart book for a visual perspective. Note: The data included is for the Russell 1000 and Russell 2000 benchmarks and thus more specific to the U.S. small-cap markets; however, the story is essentially the same for ex-U.S. small caps.

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The information in this article has been derived from sources believed to be accurate as of July 2014. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

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