Small Stocks Can't Win Every Year -- Or Can They?: Chet Currier
By Chet Currier
March 30 (Bloomberg) -- Small-capitalization stocks are at it again.
As the first quarter of 2007 comes to a close, they are doing the same thing they have done every year since the end of the 1990s. They are outperforming big stocks in the U.S. market.
Through the middle of this week, according to Bloomberg data, the Standard & Poor's 600 Smallcap Index showed a year-to- date advance of 2.9 percent, including dividends, while the S&P 500 Index, dominated by big stocks, struggled to a 0.4 percent gain.
That comes atop a stretch of seven years in which the small-cap index climbed at an 11.5 percent annual rate while the 500 index could do no better than 1.1 percent a year. A total trouncing, by any standard.
How long can they keep this up? In a world subject to the iron principle of reversion to the mean, big stocks are often said to be ``overdue'' for a turn as the market leader. Even if the timing can't be predicted, big stocks are widely regarded as the place to look for bargains nowadays.
Money managers are ``most bullish for large-cap growth, expecting the valuation imbalance to correct itself,'' the Russell Investment Group reported this week in its latest quarterly survey of more than 200 investment managers. The smart money started making this contrarian call at least two years ago -- and persuasively so, even to the ears of some confirmed small-stock partisans.
Too Soon
``In the 2005 third-quarter report to shareholders, I expressed concerns about small-cap valuations,'' says Chuck McQuaid, chief investment officer at Columbia Wanger Asset Management LP, and manager of the $19.6 billion Columbia Acorn Fund, which specializes in small to medium-sized companies. ``I was perhaps early or maybe just plain wrong,'' McQuaid writes in the fund group's latest annual report.
Back in the late 1990s, big stocks were king. As their prices soared, admiring fans proclaimed that bigness carried a powerful advantage in the emerging global economy. After that bubble burst, a countervailing case for the small and the nimble began to emerge.
Smaller companies can excel at innovation and adaptability. Big companies can't do those things well, no matter how hard they try, because they have a large stake in the status quo which they must protect.
It's easy to root for small companies. Who likes and admires big bureaucracies? The question that remains to be addressed is, what do the numbers say?
Side by Side
Presumably, after seven years of market-beating performance, small stocks are no longer the roaring bargains they were at the end of the 1990s. Bloomberg data show the price-earnings ratio of the S&P 600 small-stock index at about 22-to-1, versus 17-to-1 for the big-stock-dominated 500 index.
Those ratios, based on the most recent 12 months' earnings for the indexes' component stocks, suggest small stocks trade at almost a 30 percent premium to big stocks. The differential shrinks to about 20 percent, however, if we use estimated earnings for the next 12 months, which gives us a small-stock P/E of 18 and a big-stock multiple of 15.
Also in the Bloomberg data, we find estimated earnings growth for small stocks over the next 12 months at 20 percent, against just 11 percent for the big stocks. Hmm, turns out that the small-stock index P/E stands at less than the projected earnings growth rate for the year ahead, while with big stocks the P/E exceeds earnings growth by four percentage points.
Holy style boxes, Batman! Using this common calculation, sometimes known as the PEG (price-to-earnings-growth) ratio, small stocks still look like a better bargain than big stocks!
What Matters Most
A little restraint is in order. My math is pretty crude, based on only one of countless possible combinations of indexes and estimates. And of course, whether anybody's future estimates become actual earnings remains to be seen.
But at least this kind of exercise asks a meaningful question -- more meaningful than, say, how many more years of outperformance small stocks might have left in them. All asset classes aren't necessarily created equal, and none of them remembers what results it produced last year or the year before.
Yes, small stocks' winning streak will most likely run out sometime. But no, there is no compelling reason why that time has to be now.
(Chet Currier is a Bloomberg News columnist. The opinions expressed are his own.)
