Do Small-Caps Look Attractive Versus Large-Caps? by Francis Gannon – The Royce Funds

Co-CIO Francis Gannon shows that small-cap stock valuations have been growing more attractive relative to large-cap even in the context of small-cap recovering nicely.

How quickly perceptions change! Not even three months ago, around the recent market low on February 11, some investors were asking us how much lower small-caps could go?

We argued in late January that small cap investors should think more about buying than selling. Since that mid-February low, small caps, as measured by the Russell 2000 Index, have surged back 19.0% through the end of April.

So naturally the most common question has since shifted to, “Have I missed it, or are small-caps still attractively valued, particularly versus large caps?”

The inquiry is understandable, as large caps, measured by the S&P 500 Index, have only advanced 13.4% during this same recovery period from 2/11/16-4/30/16.

Moreover, some investors are increasingly concerned about a market in which organic revenue growth has been harder to come by, margins are under pressure, and overall uncertainty reigns with regard to prospects for the global economy.

Typically as investors’ risk aversion increases, small-caps have a tougher time.

A significant part of the small cap vs. large cap answer lies in the current valuation picture. The good news—for us as small-cap specialists and, we think, for our clients as well—is that small-cap is getting cheaper relative to large-cap.

Through 3/31/16, for example, the Russell 2000 Index was selling at only a 3% P/E premium to the Russell 1000 Index, compared to a 24% premium at year-end 2013.

Commentary from our friends at Furey Research Partners lends further support to this point.

These two charts based on Furey’s initial observations show that small cap’s relative valuations were at 13-year lows at the end of March 2016. This is based on both the median of the last 12 months’ P/E ratios (the top chart) and on the median last 12 months’ enterprise value/EBIT (the bottom chart) for the Russell 2000 vs Russell 1000.

Relative Valuations Are Narrowing

Russell 2000 vs Russell 1000 Median LTM P/E (ex. Negative Earnings Companies)

Small-Caps

Russell 2000 vs Russell 1000 Median LTM EV/EBIT (ex. Negative EBIT Companies)

Small-Caps

Small-Caps vs Large Caps

What these charts reveal is that small-cap stock valuations, as measured by the Russell 2000, have been growing more attractive relative to large-cap even in the context of small-cap recovering nicely following the 2/11/16 low.

Perhaps counterintuitively, this result is likely driven by increased attention on earnings growth—small-caps are trending ahead of their bigger counterparts in terms of earnings growth.

We have been arguing for some time that earnings growth is likely to remain the decisive factor in market leadership going forward.

As small-cap investors who prioritize profitability in our value, core, and growth approaches, we think this is a highly positive development.

Stay tuned as we look at the valuation picture within small-cap…