Are Small Caps Too Pricey?

Are Small Caps Too Pricey?

By JONATHAN CHENG
The market's smallest stocks are commanding the largest premiums—and some of their biggest fans are becoming alarmed.

The Russell 2000 Index, which comprises about 2,000 stocks with small market capitalizations, is within about 2% of a record closing high. It is a milestone that it looks destined to reach well before larger peers such as the Dow Jones Industrial Average and the Standard & Poor's 500-stock index, which are off their record highs by 13% and 16%, respectively.

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The rally from the March 2009 bottom has seen the Russell 2000 rise 143%, topping the Dow's 89% gain and the S&P's 95% rise. And the Russell has continued its advance this year, rising 6.6%.
.Small companies now command the widest premium over large-cap stocks in at least a generation, based on the ratio of price to earnings. Small caps, which typically have a market value of about $2 billion or less, often do better than large-cap stocks in the first stages of a recovery. With valuations so high, some are girding for a period of underperformance by the Russell 2000.

The Russell 2000 is trading at almost 18 times one-year forward forecast earnings, a record high, according to Bank of America Merrill Lynch. That P/E ratio is about 1.3 times the P/E of the market's largest 200 companies as measured by Russell Indexes, according to Lori Calvasina, director of small-cap equity strategy at Credit Suisse, the highest since at least 1979, when her data begin.

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.The valuation gap has approached this level only twice before, in 1983 and 2007. After both instances, small-cap stocks vastly underperformed their larger brethren, Ms. Calvasina says.

"We're on borrowed time," she says. "We are transitioning into a new phase of leadership in which large will outperform small."

The rally from the March 2009 bottom has seen the Russell 2000 rise 143%, topping the Dow's 89% gain and the S&P's 95% rise. And the Russell has continued its advance this year, rising 6.6%.

Some of the Russell's top performers have already doubled this year, including Alon USA Energy, an oil refiner; Pharmasset, a developer of hepatitis C treatments; Vonage Holdings, a broadband messaging service; and Silicon Graphics International, a computer-server and storage company.

Only about 11% of Russell 2000 stocks are trading at less than 10 times future earnings, according to Steven DeSanctis, head of U.S. small-cap strategy at Bank of America Merrill Lynch, who says he considers valuations "stretched."

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."There's not a lot of good value," he says. In just four months, the Russell small-cap index is approaching the gains that he forecast for the entireyear.

Small-cap investors are increasingly downbeat. In a recent Credit Suisse survey of small-cap investors, 36% of 126 respondents said they expected large-cap stocks to lead the market over the next six to 12 months, compared with 31% for small- and midcap stocks, showing a rare lack of confidence in small caps, Ms. Calvasina says.

Some argue that the Russell's surge highlights how small companies have been able to better grow revenue and cut costs in a tough economy. And that shows they may still have legs, says Bhupinder Singh, small-cap equity strategist at J.P. Morgan. He predicts the Russell, which closed on Friday at 834.99, will rise to 950 by the end of the year, a gain of about 14%.

Small caps largely outpaced bigger companies in revenue growth in the past few quarters, Mr. DeSanctis says. They also slashed costs by 10.7% during the downturn of 2008 and 2009, according to Mr. Singh, which compares with 3.2% among S&P 500 companies.

Smaller companies have also benefited disproportionately from the Federal Reserve's moves to pump liquidity into the financial system. The added cash has helped buoy all risky assets—and small caps are considered among the most risky in the stock market.

As investors tiptoe back into stock mutual funds, some argue that the investors that have so far missed the small-cap rally may be tempted to jump in. "Small-cap stocks have been persistently out of favor, even as they've been persistently outperforming large caps," says James Paulsen, chief investment strategist at Wells Capital Management. "It's doubled while nobody's been in it, and that's what allows it to keep going."

Many investors view the health of the U.S. economy as a key determinant of the future for small-cap companies, which typically rely heavily on the U.S. for business. But many believe bigger opportunities are likely to come from outside the U.S., particularly emerging markets—an advantage for the bigger, multinational companies that populate the S&P 500 and Dow.

"With the U.S. growing at only 3% and global GDP [growth] more like 4.2%, small caps are going to be hamstrung" by their relative lack of exposure to emerging markets, says Mr. DeSanctis of BofA Merrill Lynch.

Investors are expecting small caps to show 19% earnings growth for the January-to-March quarter just concluded, compared with 13% to 15% for the S&P 500, he says. But he thinks that small-cap forecast is unlikely to be achieved at a 3% economic growth rate.

Among other headwinds, the Russell 2000 is more heavily weighted toward consumer discretionary stocks than the S&P 500 and less exposed to energy stocks. If oil continues to rise, that may mean the Russell 2000 lags behind. Financial companies are significantly more heavily weighted in the Russell 2000, in favor of regional banks that are reliant on mortgage lending in the midst of a disappointingly weak housing recovery.

But if the economic recovery stays on track, as many expect, small caps may well continue to rise. "If you think the broad market has more upside, then smalls are going to lead it," says Wells Capital's Mr. Paulsen. "I don't think it'll be a two-year run in the markets led by large caps."

Mr. Paulsen says he believes the economic recovery is still in its early phases, when small-cap and cyclical stocks tend to perform the best.

"Do you think firms are overstaffed? Have they spent their cash flows yet? Is confidence too high? I think we're still in that sweet spot for small caps," he says. "Any way you date a cycle, we're still early and small caps benefit."

Write to Jonathan Cheng at jonathan.cheng@wsj.com