Author: Jim Bowerman
Covestor portfolio: Fundamental Opportunism
As you can tell from my personal description, I generally consider myself a value investor and look for companies that I believe are trading cheaply compared to intrinsic value. In addition, I’ll occasionally glean ideas from the macro environment to give me some hints on where to look for those companies. Right now, it appears to me that large caps are significantly undervalued in relation to small caps.
Much has been written about the outperformance of small cap stocks over the last century. However, I don’t believe this will necessarily continue. Fifty years ago, the difference between buying small cap versus large cap stocks was much wider than it is today (there is no real cost difference to an investor to invest in the smallest company on the Russell 2000 versus buying Apple stock). As usual, a few valuation metrics usually determine how an index will perform over the long term. Expecting 10% annual returns while the index P/E is above 25 is unrealistic in my view, however if the P/E drops to around 10, then a 10% average gain going forward is far more likely if you hold on long enough.
So lets dig a bit deeper and look at the P/E ratio for the large cap stocks versus the P/E ratio for the small cap stocks. The easiest way I’ve found to look up this information is on this page from the Wall Street Journal’s site.
You’ll notice there are listed P/E ratios for Dow Jones Industrial Average stocks (obviously large companies) as well as the Russell 2000 (which contains many small and midcap companies). Looking at the forward 12 month P/E estimate for each, we see that as of 11/11/2011 the Dow’s forward P/E is at 12.22. The Russell 2000 forward P/E is at 21.65. This is a significant difference. Again, each company is different and this does not mean there are no undervalued small cap stocks or that every Large cap stock is cheap. However it does give us some hints.
To get a slightly more historical perspective on the large cap vs small cap P/E spread, here is a good article by Ian Wyatt, written in April 2011.
You’ll notice half way down a graph that plots the ratio of the P/E values of the indexes (ratio is P/E of Russell 2000 divided by P/E of Russell Top 200 – a large cap index). A high ratio means the small cap stocks have a higher P/E value than the large cap stocks. At the time of that article, the ratio was about 1.3. The Russell 2000 forward P/E was “almost 18 times one year forward forecast earnings,” while the S&P500 large cap P/E was at 13.7. Unfortunately the Dow Industrial P/E is not listed, however the S&P500 large cap index is a close estimate. Looking at the ratios and graph from April and comparing to the present we see that if anything the spread has increased – that is, large caps are even cheaper. I’m not sure when the spread between large and small will shrink, but I’m confident it will.
Until then, most of my buying will be in the large cap sector… while focusing on finding value within that market segment.
