By Philip van Doorn
Small-cap stocks, as a group, are bargain-priced relative to more popular large-caps, but you may be surprised at just how cheap they are. And wait until you see their performance from similar valuation levels.
Look at this 20-year chart, which shows the weighted forward price-to-earnings ratio for the S&P Small Cap 600 Index /zigman2/quotes/210599868/delayed SML -2.23% versus the large-cap benchmark S&P 500 Index /zigman2/quotes/210599714/realtime SPX -1.72% :
William Watts reported on what appears to be a breakout for small-cap stocks after eight months of relatively flat performance. That is based on the movement of the Russell 2000 Index /zigman2/quotes/210598147/delayed RUT -2.48% .
In this article, we are focusing on the S&P Small Cap 600 Index, which is far more selective than the Russell 2000 because because most of its companies are profitable. Standard & Poor’s criteria for initial inclusion in the index includes positive earnings for the most recent quarter and for the sum of the most recent four quarters.
Aside from the early coronavirus pandemic doldrums of March 2020, the S&P 600 Small Cap Index hasn’t traded this low, relative to the S&P 500, in 20 years.
Here’s a breakdown of the relationship between current and average forward P/E ratios for the two indexes, using weighted data compiled by FactSet:
|Forward price-to-earnings ratios|
|Index||Current||3-year average||5-year average||10-year average||15-year average||20-year average|
|S&P Small Cap 600||15.63||16.69||16.60||15.81||15.32||15.34|
|Valuation of S&P Small Cap 600 to S&P 500||72%||86%||89%||95%||99%||98%|
The small-cap group typically trades much closer to the valuation of the large-caps than it does today.
Now take a look at a 20-year comparison of total returns for the two indexes:
In an extended bull market, driven in part by historically low interest rates, it is understandable that the best-known stocks (the large-caps) have had the most benefit. But all of the above argue for adding exposure to small-caps for the long term, as part of a diversified portfolio, especially if you have a lot of money in an S&P 500 index fund or exchange traded fund.
For a shorter-term case, see this comparison of aggregate consensus 2022 estimates among analysts polled by FactSet for the two indexes:
|Sales per share|
|S&P Small Cap 600||$1,170.21||$1,261.61||7.8%|
|Earnings per share|
|S&P Small Cap 600||$82.41||$94.04||14.1%|
|Free cash flow per share|
|S&P Small Cap 600||74.46||89.86||20.7%|
Good numbers across the board — but the estimates are higher for the small-cap group.
For both groups, the free-cash-flow estimates are comforting. Free cash flow is a company’s remaining cash flow after planned capital expenditures. It is money that can be used for expansion, dividend increases, stock buybacks or other corporate purposes.