Over time, small cap stocks have typically commanded a premium price-to-earnings ratio versus large caps. Over the last few years, the dispersion between small cap valuations and large cap valuations has widened meaningfully. On an absolute basis, small caps (as measured by the Russell 2000® Index) are trading at roughly a 20% discount when compared to the long-term average (from 10/31/2002 – 10/14/2022). Historically, when small caps have traded at valuation levels like those seen today, there has been compelling forward performance as measured by total return.
Lord Abbett: A Strengthening Case For Small Cap Stocks
October 27, 2022
Figure 1. Current Valuations Point to Opportunity in Small Caps
Five-year forward return based on monthly observations of projected 12-month price-to-earnings ratios for the Russell 2000® Index, November 1998–September 2017
Source: FactSet. Data as of October 14, 2022. Forward returns data through latest applicable month. NTM PE=Expected price to-earnings ratio for the next 12 months.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
While the relative and absolute valuation levels may seem unsurprising given the macroeconomic backdrop—an increasingly hawkish U.S. Federal Reserve, strong inflation, and the potential for a U.S. recession—we believe the steep discount in valuations may not be warranted. From an earnings perspective, we continue to see analysts’ expectations for the earnings of large cap stocks (based on the Russell 1000® Index) revised downward, while earnings expectations for small caps have remained more resilient.
Figure 2. Expected Earnings for Small Caps Remain Resilient Versus Larger Peers
Estimated three- to five-year earnings-per-share growth for the Russell 1000® Index and Russell 2000® Index at the indicated dates
Source: FactSet. Data as of October 14, 2022.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Another consideration for investors interested in small caps is the current strength of the U.S. dollar. Dating back to the 1970s, during periods of dollar increases of 15% or more, small caps, as represented by the Russell 2000® Index, have returned 13.2% annualized versus 10.3% for the S&P 500® Index.1 In the past, we have noted that small cap companies historically have derived most of their revenue from U.S.-related operations. This has helped to shield their overall competitive position and profitability versus firms that derive a larger share of revenues outside the U.S. Companies with a greater non-U.S. focus may be hurt by a stronger dollar in two ways. First, they may see weaker demand for their goods and services, as the strong dollar makes their offerings more expensive for non-U.S. buyers. Second, they may see a negative impact on profits from currency-translation factors.
Final Thoughts
While there are reasons to be optimistic about the small cap space, we believe challenges, such as inflation and higher interest rates, will lead to a difficult operating environment for companies across the market capitalization spectrum. This will likely result in a greater dispersion between the winners and the losers in the equity market, particularly in small caps. Active managers with time-tested fundamental research capabilities and expertise in security valuation may be best positioned to identify those winners—and steer clear of the losers. Further, limited coverage by securities analysts across the asset class may actually depress valuations of otherwise strong small cap companies. Firms with research focused on these smaller companies may be in the best position to identify compelling opportunities in under-followed stocks and potentially generate attractive returns.
Source: https://www.lordabbett.com/en-us/financial-advisor/insights/markets-and-economy/a-strengthening-case-for-small-cap-stocks.html