Stay the Course in Small Caps

Small-cap stocks sold off in the third quarter, but now is not the time to abandon the market cap segment. Jonathan Coleman, Co-Portfolio Manager of the Janus Venture Fund, gives his perspective on current small-cap valuations, and why an allocation to small caps is beneficial in an environment where the U.S. economy is on stronger footing than the rest of the world.

After recent sell-off, small caps deserve a closer look

It’s officially gut-check time for small-cap investors again. Risk tolerances waned in the third quarter, and similar to previous periods when risk tolerances faded, small-cap stocks bore the brunt of the sell-off.

At a 10,000 foot view, the sell-off may have seemed warranted. The global economy is slowing, and that’s putting it mildly. The Fed is wrapping up quantitative easing. And heading into the third quarter, valuations for small-cap equities looked stretched, especially compared to their large-cap brethren. We suggest you don’t let a few clouds at the 10,000 foot level obfuscate the view of what’s currently going on in small caps, however.

Many small-cap investors have a history of heading for the exits when a few clouds have gathered, and subsequently missed out on much of the asset class’ potential. This is why the gap between the Russell 2000 Growth Index’s returns and the returns captured by the average small-cap investor is much greater than the disparity between the Russell 1000 Growth Index’s returns and the returns captured by the average large-cap investor. The current macroeconomic and market environment presents another moment when small-cap investors should take a closer look and understand what drove recent volatility, and what we believe could lie ahead for the asset class.

A closer look at valuations

Stocks enjoyed sharp gains in 2013, and nowhere was the ride more enjoyable than for U.S. small-caps. However, much of that rise was fueled by multiple expansion, rather than earnings growth, which left most small-cap stocks trading at the higher end of historical valuations. Perhaps more alarming, a few pockets of the small-cap market were trading at valuations not seen since the last tech bubble.

A number of stocks tied to hyper-growth industries such as biotech, consumer Internet and cloud computing are yet to turn a profit, and instead trade at high multiples of revenue. We’ve said for more than a year now that these pockets of the market are a dangerous place to play. While a few of these companies will be game changers in the respective environments in which they compete, a large portion of these stocks have been bid up by momentum investors who are willing to pay an exceedingly high price for potential, unproven growth. And while momentum stocks have sold off some during the spring and summer, they would still need to fall much further to appeal to an investor base using traditional valuation metrics such as a discounted cash flow analysis.

This narrow set of risky stocks has grabbed headlines, and we believe it caused investors to question small-cap valuations more broadly. A broad sell-off ensued in the third quarter, and has left a wide swath of small-cap companies that were not part of the momentum hype with attractive valuations. Consider that as of September 30, all profitable firms in the Russell 2000 Index trade at only a 4.6% premium to their long-term averages since 2001. Similarly, if one strips out the biotech/pharma and Internet software and services subsectors, where many of the momentum stocks lie, the rest of the index has a P/E ratio that is actually 1.1% below its average level since 2001.*

The premium valuation in which small caps trade relative to large caps has also come back to normalized levels. Reasonable valuations suggest small caps could once again start outperforming their large-cap peers, if you believe they face similar growth prospects. In fact, we believe small-cap growth rates could be higher.

If global economic growth looks weak, stay close to home

Fears about the global economy caused risk tolerances to snap back, and small caps to sell off broadly, but somewhat ironically, small-cap stocks will likely be less impacted by the weak global economy than larger companies. On average, U.S. small-cap companies derive only 18% of their revenue internationally, compared to 40% for U.S. large-cap companies. For small-cap companies, the operating environment has remained the same or has slightly improved during the year.

Where to go from here

We don’t expect the high level of returns that small-cap growth stocks achieved in 2013. The era of multiple expansion is largely over, and earnings growth will be needed to drive returns from here. But with small-cap stocks currently standing at a much more reasonable starting point, and with more of their revenues generated from the sole source of economic stability around the globe (the U.S. economy), we think the market cap segment will be an important source of returns in what is likely to be a lower return environment. In our view, turning your back on the asset class now would mean repeating the mistake that has historically plagued many small-cap investors.

*Furey Research Partners

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