Small Cap Earnings Growth At An Inflection Point: Citi

Small Cap Earnings Growth At An Inflection Point: Citi

Earnings growth expectations are low against their historic average, close to troughs seen in the aftermath of previous recessions, but with metrics improving they may be set to start climbing again, says Citi analyst Scott T. Chronert.

“A combination of falling growth expectations, low rising/falling estimate ratios and positive revision trends over the past few months has left earnings growth expectations toward the low end of historical ranges,” writes Chronert. Both small cap and mid cap trailing growth is in the same range as six of the last seven cyclical low points (EPS growth after the last recession is the outlier in both cases).

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Earnings growth drivers

On the other hand, valuations are at the high end of the historic range. “This implies increased reliance on earnings growth drivers as a market trigger as we head toward 2014,” writes Chronert. Small and mid-cap companies have higher valuations than large-cap, and that gap got larger during Q3. Small-cap continues to be a better prospect than mid-cap companies, although small/mid valuation ratios have been more steady than small/large.

But while low earnings growth expectations and high valuations might make small companies look like a bad deal, conditions are similar to those when small cap growth hit an inflection point and began to climb steadily. Predicting exactly when the inflection will happen is of course difficult, but if the economy as a whole continues to recover it seems reasonable that small companies should start to climb out of their weak position soon.

Forward earnings expectations

“Signs of stabilization/improvement in forward earnings expectations are apparent. Trailing earnings growth is now approaching levels most typical of recessionary periods,” writes Chronert, noting that there are already some early signs of improvement.

Value outperformed growth during the third quarter, as earning growth rates for Growth stocks increased sequentially. Growth strategies have outperformed value strategies for the year-to-date for companies of any size, although the biggest difference can be seen with small-cap firms.

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Internal correlations, up in the second quarter, fell slightly in Q3, which Chronert says is an indication of more stock specific differentiation and more positive sentiment in general, while a falling RSI is close to oversold levels.

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