Small-Caps are Outperforming

February 14th, 2013
in contributors, syndication

Answering the Small-Cap Skeptics: P/E Ratios and Performance Time Periods

Investing Daily Article of the Week

by Jim Fink, Investing Daily

January 2013 is now history and small-cap stocks beat large-cap stocks by more than a full percentage point during the month: 6.24% to 5.12%.  Mid-cap stocks did best of all at 7.08% (more on them later):

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Follow up:

In fact, the small-cap Russell 2000 Index (^RUT) hit 12 new all-time closing highs in January, whereas the large-cap S&P 500 Index (^SPX) remains 4% below its 2007 all-time high. January outperformance by small caps is very good news for the remainder of 2013. Historically, whenever small caps outperform large caps in January, they go on to outperform large caps for the entire calendar year by an average of more than 7 percentage points.

Answering the Small-Cap Skeptics

Skeptics argue that small caps may not outperform because the forward price-earnings ratio (PE) of Russell 2000 stocks is higher than the forward PE ratio of S&P 500 stocks – 15.1 vs. 13.3. Although true, this is a half truth in two respects. First, large caps are experiencing record profit margins that are likely unsustainable, so their low PE ratio is based on peak earnings. According to UBS (page 19), in 2012 large-cap EBIT (i.e., operating) margins were a whopping 7.3 percentage points higher than small-cap operating margins – a sharp contrast to the 2001-06 time period when small-cap margins only trailed by the more-normal 4 percentage points. It’s not a coincidence that large-cap stocks outperformed small caps between late April 2006 and late December 2012 by more than 5 percentage points on a total return basis. Large-cap operating margins took off to the upside and so did the large-cap stocks. Earnings matter!

Furthermore, current small-cap operating margins of 7.1% remain 18% below their last-cycle peak reading of 8.7% in 2006, so the “E” in the small-cap PE ratio is set to increase, which will make the small-cap PE ratio look cheaper.. As I wrote last week in Small Caps: The Time to Invest is Now, small-cap stocks are more sensitive to the macroeconomic environment, so the sluggish economic recovery since the 2008 global financial crisis has left them with middling operating margins that will explode to peak levels if the economy strengthens and inflation takes hold. Not only does a peak in large-cap operating margins make small-cap growth look relatively more attractive to investors, but it also may spur large-cap companies to go on an M&A binge where they “buy growth” via small-company takeovers. Since takeovers are usually done at a significant premium to the current market price, small-cap investors would reap a quick profit from getting bought out.

Analyst estimates of long-term earnings growth already recognizes the higher growth potential in small caps looking forward. Whereas large caps are estimated to experience annualized earnings growth of only 10.4%, small-cap earnings are expected to grow a much faster 12.5% per year.  When you combine PE ratio with future earnings growth, the result is the PEG ratio which is arguably a much more accurate measure of current valuation than the PE ratio alone. On a PEG ratio basis, small caps are cheaper than large caps (footnote 8):

Arbitrary Performance Time Periods and Reversion to the Mean

Skeptics also point out that small caps outperformed large caps for 12 years between April 1999 and March 2011, so it is large caps turn to shine. But 12 years is an arbitrary time period. Long-term market-cap cycles are typically measured in 20-year time periods – not 12 years. Indeed, as Charles Schwab pointed out in May 2011:

Even after strong relative performance over the past 10 years, small-cap stocks (as represented by the Russell 2000) have underperformed large-caps (S&P 500 Index) on a buy-and-hold basis since 1983. That’s 28 years!

Similarly, James O’Shaughnessy has written:

The good news for long-term investors is that even with their recent strong performance, small-cap stocks are still a great opportunity. They are emerging from the largest performance gap from large-cap stocks in history. While large-cap stocks were recently dangerously above their long-term average, small-cap stocks are in the Promised Land – emerging from a twenty-year period in which their performance was one standard deviation below their long-term average.

Our most conservative forecast for small stocks over the next 20 years is 7.6 to 9.6 percent per year – nearly double that of large-cap stocks.

Research on Rolling 20-Year Time Periods is Very Encouraging for Small-Cap Stocks

Although the 20-year period for small-cap underperformance O’Shaughnessy was referring to on pages 65 & 70 of his 2006 book The New Rules for Investing Now: Smart Portfolios for the next 15 Years cited above ended in March 2003, the fact remains that O’Shaughnessy’s projected 20-year period of small-cap outperformance won’t run out until March 2023 – more than ten years from now.

Furthermore, O’Shaughnessy’s 2006 research can even be applied to evaluate small-cap stocks’ 20-year expected return starting today in February 2013. O’Shaughnessy looked at all 20-year rolling time periods beginning each month between June 1947 and December 2004, which constitutes 691 rolling time periods total. He found that small-cap stocks outperformed the S&P 500 in 84 percent of these 20-year periods. But small-cap performance is even better when the prior 20-year period has been below average by one-standard deviation or more. Given that the average annualized return of small-cap stocks in any 20-year rolling period was 10.42 percent and the standard deviation of returns was 2.94 percent, a below-average 20-year annualized return equals 7.48 percent or less (10.42-2.94).

What annualized return has the Russell 2000 generated over the past 20-year period between January 1993 and January 2013?  The answer is 7.11 percent, which is still below the 7.48 percent one-standard deviation threshold.

Russell 2000 Has 7.11 Percent Annualized Return Over Past 20 Years

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That’s amazing, considering that small caps have outperformed large caps over the past 5- and 10-year periods. O’Shaughnessy found that whenever the 20-year annualized return of small caps is 7.48 percent or less:

Twenty years later the minimum return was 11.76 percent, the maximum 16.75 percent, and the average 14.03 percent. Small stocks returned more than 13 percent per year over the next twenty-year period 68 percent of the time! And they always provided returns in excess of the twenty-year average [of 10.42 percent].

Bottom line: an arbitrary 12-year period of small-cap outperformance between April 1999 and March 2011 has no rationale basis and shouldn’t be used to project future large-cap outperformance based on the concept of “reversion to the mean.” Unlike O’Shaughnessy’s study of rolling 20-year time periods, none of these small-cap skeptics have produced data on rolling 12-year time periods and tested to see how small caps do in the subsequent 12-year time periods.

Let’s look at several non-arbitrary time periods looking back into the past from now (end of January 2013):

Since over the very long term of 86 years (1926-2012), small caps have outperformed large caps, the fact that large caps have outperformed over the past 20- and 30-year periods suggests – thanks to reversion to the mean – that small caps will outperform over the next 20- and 30-year periods.

New also this week from Jim Fink:  Mid-Caps:  The "Sweet Spot" of Investing

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