article 05-09-2016

Do Small-Caps Look Attractive Versus Large-Caps?

Co-CIO Francis Gannon shows that small-cap stock valuations have been growing more attractive relative to large-cap even in the context of small-cap recovering nicely.

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How quickly perceptions change! Not even three months ago, around the recent market low on February 11, some investors were asking us how much lower small-caps could go?

We argued in late January that small cap investors should think more about buying than selling. Since that mid-February low, small caps, as measured by the Russell 2000 Index, have surged back 19.0% through the end of April.

So naturally the most common question has since shifted to, "Have I missed it, or are small-caps still attractively valued, particularly versus large caps?"

The inquiry is understandable, as large caps, measured by the S&P 500 Index, have only advanced 13.4% during this same recovery period from 2/11/16-4/30/16.

Moreover, some investors are increasingly concerned about a market in which organic revenue growth has been harder to come by, margins are under pressure, and overall uncertainty reigns with regard to prospects for the global economy.

Typically as investors' risk aversion increases, small-caps have a tougher time.

A significant part of the small cap vs. large cap answer lies in the current valuation picture. The good news—for us as small-cap specialists and, we think, for our clients as well—is that small-cap is getting cheaper relative to large-cap.

Through 3/31/16, for example, the Russell 2000 Index was selling at only a 3% P/E premium to the Russell 1000 Index, compared to a 24% premium at year-end 2013.

Commentary from our friends at Furey Research Partners lends further support to this point.

These two charts based on Furey's initial observations show that small cap's relative valuations were at 13-year lows at the end of March 2016. This is based on both the median of the last 12 months' P/E ratios (the top chart) and on the median last 12 months' enterprise value/EBIT (the bottom chart) for the Russell 2000 vs Russell 1000.

Relative Valuations Are Narrowing
Russell 2000 vs Russell 1000 Median LTM P/E (ex. Negative Earnings Companies)

Median LTM P/E chart

Russell 2000 vs Russell 1000 Median LTM EV/EBIT (ex. Negative EBIT Companies)

Median LTM P/E chart

What these charts reveal is that small-cap stock valuations, as measured by the Russell 2000, have been growing more attractive relative to large-cap even in the context of small-cap recovering nicely following the 2/11/16 low.

Perhaps counterintuitively, this result is likely driven by increased attention on earnings growth—small-caps are trending ahead of their bigger counterparts in terms of earnings growth.

We have been arguing for some time that earnings growth is likely to remain the decisive factor in market leadership going forward.

As small-cap investors who prioritize profitability in our value, core, and growth approaches, we think this is a highly positive development.

Stay tuned as we look at the valuation picture within small-cap…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments.  The Russell 1000 index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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