Value – It's Not All Relative

We have recently been asked to weigh in on how valuations in the smaller company universe stack up against those of the large-cap universe. While we understand the interest in this area, and are more than happy to comment, we also think the question somewhat misses the mark for several important reasons.

First, the indexes most often used to compare valuations are so starkly different in their size (number of companies), composition, and component parts that it would only be useful if contrasting passive investment strategies that replicated the two indexes. It seems to us that the more useful approach would be to compare and contrast the opportunity set presented by each market cap segment.

Our small-cap benchmark, the Russell 2000 Index, is an unmanaged and capitalization-weighted index of domestic small-cap stocks. It measures the performance and valuation of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index, which itself is simply the 3,000 largest companies in the U.S. equity market. On the other hand, the most commonly used large-cap benchmark, the S&P 500 Index, is a managed index of U.S. companies selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors.

So while the Russell 2000 is essentially a random assortment of companies chosen by cap size alone, the S&P 500 is intentionally constructed with a qualitative bias, making comparisons of the opportunities each presents more than a little flawed.

Second, and more important, the selection universe for active investors is quite different in these two segments of the market. For example, the small-cap index consists of 2,000 companies, but our selection universe here at Royce ranges much farther, comprising more than 5,000 companies. The large-cap selection universe is not much larger than the S&P 500 and consists of roughly 80% fewer companies than the small-cap universe. Given the large variance in the number of companies between small-cap and large-cap, it seems reasonable that the dispersion of quality and valuation will differ a good deal as well.

The Russell 2000 has a significant percentage of what we categorize as lower-quality companies that significantly skew the average valuation metrics for the index, while the S&P 500 is much more consistent from a quality standpoint and therefore has a generally narrower opportunity set for uncovering mispriced companies.

So what valid comparisons can be made between the two size segments for investors who seek to optimize their equity asset allocations? One method would be to look at subsets of each index, organized by metrics important to investors, such as ROIC (returns on invested capital), earnings growth rate or balance sheet leverage. For example, we believe that one useful comparison would be to examine the average P/E for the top quartile of Russell 2000 companies based on ROIC compared to the average P/E of the top ROIC quartile for the S&P 500 to get a sense of the relative potential contained within each index.

Better yet would be to examine specific actively managed portfolios and consider the absolute potential of each based on what each is holding. When we look at our portfolios, we are more interested in how they stack up in terms of risk-reward potential relative to investment opportunities both passive and active, small-cap and large-cap, etc.

At Royce, our time-tested discipline emphasizes companies with what we think are compelling absolute valuations. Our search centers on businesses that look absolutely inexpensive based on our analysis of various key fundamentals, such as balance sheet strength, history of earnings and free cash flow generation, and their relation to the company's stock price. We value these characteristics irrespective of what others might be doing. In addition, the large and highly diverse small-cap universe generally possesses significant opportunity regardless of what the averages might lead you to believe, which is why we see it as an evergreen source of fresh ideas.