Small-cap growth stocks are the cheapest they’ve been in at least 24 years. Here’s how one manager is playing it. Deep Dive

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 +2.40% relative to that of the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.06% .

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 +2.74% 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 +2.40% .

Here’s a look at small-cap index ETF valuations relative to the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY -0.06% 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%
Source: FactSet

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%
Source: FactSet

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 +0.09% /zigman2/quotes/202587765/delayed CA:FSV -0.20% 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 -0.47% , which specializes in finding growth stocks off the beaten path, he said.