Are Small-Cap Stocks Cheaper than Large Caps? Yes – If You Ignore This One Key Fact
Small-cap stocks have recently gained attention as potential bargains for investors as they have suffered greater declines than large-cap equities in the wake of market volatility. However, a closer examination reveals that small-cap stocks may not be as attractively priced as they seem, particularly when one crucial factor is considered: the prevalence of money-losing companies within the small-cap index.
Russell 2000 vs. S&P 500: A Clash of Price-Earnings Ratios
The Wall Street Journal indicates that the small-cap Russell 2000 index trades at a significantly higher price-earnings (P/E) ratio of 32.1, compared to the large-cap S&P 500’s P/E of 22.1. This difference suggests a premium for small-cap stocks, despite the common narrative of their undervaluation.
However, this situation is not as clear-cut as it appears. Many investors rely on varying data sources that yield dramatically different P/E calculations. For example, iShares, a renowned exchange-traded fund provider, reports a trailing 12-month P/E for the Russell 2000 of just 15.2—less than half of what was reported by the Wall Street Journal. This striking discrepancy arises because iShares excludes companies that are losing money from its calculations.
The Impact of Loss-Making Firms in the Russell 2000
According to data from FactSet, over 40% of the companies in the Russell 2000—837 in total—have not turned a profit in the last 12 months. This high proportion of unprofitable firms significantly skews the index’s P/E ratio, creating an illusion of attractive pricing when, in reality, the sector as a whole may not be as appealing.
This trend of decreasing profitability in smaller companies is part of a broader economic phenomenon termed the “Winner-Take-All” economy, as identified by economists Thomas Noe of Oxford University and Geoffrey Parker of Dartmouth College. This shift highlights the increasing concentration of corporate profits within a limited number of large, profitable businesses, which further complicates the investment landscape for small-cap stocks.
Identifying Value Among Small-Cap Stocks
While the small-cap sector may not be uniformly undervalued, that doesn’t eliminate the potential to uncover attractive individual stocks. Investors should focus on identifying small-cap stocks with low P/E ratios and positive financial performance. For instance, research conducted by Dartmouth professor Ken French reveals that from July 1951 to 2024, a portfolio comprised of small-cap stocks with low P/Es outperformed a portfolio of high P/E small caps by an impressive 5.1 annualized percentage points.
To assist investors in identifying promising opportunities, an analysis was conducted on the current recommendations from investment newsletters monitored by the auditing firm. The goal was to narrow down the Russell 2000 stocks focused on low forward P/Es while also ensuring they pay dividends. This led to a shortlist of 15 stocks that exhibit these criteria.
Potential Stocks to Watch
Here are some noteworthy stocks from the Russell 2000 that have a low forward P/E:
- KB Home (KBH)
- American Eagle Outfitters Inc. (AEO)
- Winnebago Industries Inc. (WGO)
- Hancock Whitney Corp. (HWC)
- First Merchants Corp. (FRME)
In conclusion, while small-cap stocks may present some opportunities for value investing, it is critical to be discerning. A significant fraction of the Russell 2000 comprises money-losing companies, which skews the overall P/E calculations. Investors should take a more granular approach, identifying individual stocks based on sound financial fundamentals rather than rushing into the small-cap sector en masse. As always, diligent research and consideration of the current market landscape will lead to more informed investment decisions.