By Philip van Doorn
Growth stocks typically trade at premium prices. But in this market, rising interest rates have turned small-cap growth stocks into a bargain group. This may be a beautiful setup for long-term investors.
The following chart, provided by Alger Director of Market Strategy Bradford Neuman, underscores the opportunity:
The chart shows the weighted forward price-to-earnings ratio for the S&P Small Cap 600 Growth Index /zigman2/quotes/210600187/delayed XX:SP600G +0.48% relative to that of the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.16% .
Alger is based in New York and manages about $35.5 billion through funds and private accounts.
In a note to clients, Neuman wrote that the current market environment “may be the best of both worlds for small-cap growth investors, given that these stocks are less expensive than small-value equities, and they generally also have higher operating margins, return on capital and stronger balance sheets.”
This is the cheapest that the S&P Small Cap 600 Growth Index has been, relative to the S&P 500, since FactSet started tracking the data in 1998. This is a subset of the S&P 600 Small Cap Growth Index /zigman2/quotes/210599868/delayed SML +0.49% that includes 332 companies exhibiting higher growth characteristics based on “sales growth, the ratio of earnings change to price, and momentum,” according to S&P Dow Jones Indices. You can read more about the index criteria here .
The index is tracked by the iShares S&P Small-Cap 600 Growth ETF /zigman2/quotes/209218027/composite IJT +0.35% .
Here’s a look at small-cap index ETF valuations relative to the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY -0.17% for 10 years through May 31:
|Index||Ticker||Current forward P/E||10-year average forward P/E||Current valuation to 10-year average||Current valuation to S&P 500||10-year average valuation to S&P 500|
|iShares Core S&P Small Cap ETF||IJR||11.88||17.66||67%||68%||103%|
|iShares S&P Small-Cap 600 Growth ETF||/zigman2/quotes/209218027/composite IJT||12.16||19.15||63%||69%||112%|
|iShares S&P Small-Cap 600 Value ETF||/zigman2/quotes/208698388/composite IJS||11.70||16.58||71%||67%||97%|
|SPDR S&P 500 ETF Trust||/zigman2/quotes/209901640/composite SPY||17.50||17.13||102%||100%|
Over the past 10 years, the iShares S&P Small-Cap 600 Growth ETF has traded well above the forward P/E valuation of SPY on average. But now it is the cheapest of the listed ETFs relative to the large-cap benchmark, at 63%.
During an interview, Neuman said that the movement of rolling forward consensus estimates among analysts polled by FactSet further underscored the inexpensiveness of small-cap growth stocks:
|ETF||Estimated sales per share – NTM – May 31, 2022||Estimated sales per share – May 31, 2021||Sales estimate Increase||Estimated EPS – May 31, 2022||Estimated EPS – May 31, 2021||EPS estimate increase|
|iShares Core S&P Small Cap ETF||$113.87||$94.37||21%||$8.45||$6.31||34%|
|iShares S&P Small-Cap 600 Growth ETF||$88.65||$73.35||21%||$9.30||$6.33||47%|
|iShares S&P Small-Cap 600 Value ETF||$141.71||$114.24||24%||$8.36||$6.64||26%|
|SPDR S&P 500 ETF Trust||$175.15||$152.60||15%||$23.79||$19.82||20%|
Over the past year, as the consensus forward 12-month EPS estimate for the small-cap growth group increased by 47%, the ETF was down 11%. Meanwhile, SPY’s EPS estimate increased 20% while its shares were flat. (Both with dividends reinvested.)
Neuman called this a “divergence between the market and fundamentals.” He further explained that since investors in small-cap growth companies are paying, in part, for cash flows that are several years away, they are especially sensitive to rising interest rates.
“Small-cap companies have grown their earnings much more quickly, and their price has gone down also much more quickly,” he said.
An attractive small-cap growth stock
Neuman named FirstService Corp. /zigman2/quotes/210530137/composite FSV -0.45% /zigman2/quotes/202587765/delayed CA:FSV +0.15% as an example of a small-cap growth stock in an industry investors may not typically associate with growth: residential property management. The company is based in Toronto and is the second-largest holding of the Alger Weatherbie Specialized Growth Fund /zigman2/quotes/207540271/realtime ASMZX +0.30% , which specializes in finding growth stocks off the beaten path, he said.