Don’t Give up on Small Caps

Don’t feel sorry for the punished small-company stocks

Small stocks have been punished this year. As of Oct. 10, the S&P 600 SmallCap Index was down 8.21% since Jan. 1. In contrast, over the same period the S&P 500 Index of large-cap stocks was ahead by 3.13%..

We view this as a potential buying opportunity rather than a reason to bail out. In our portfolio construction process we allocate amounts specifically to the small-company asset class (defined as roughly $500 million to $2 billion in market capitalization) knowing that its performance frequently diverges from that of large companies, as it has been doing of late.

An 8.21% loss is pretty close to bear-market territory for the small-caps. Although we don’t pretend to know when small-caps will bottom and bounce back, we do know that markets tend to revert to their mean performance. And that’s what we are confident will happen with the smalls.

What is behind the small-cap downturn has been valuations. The smalls have been just too pricey, relative to their earnings. As of Sept. 30, the P/E ratio for the S&P 500 was 18.42; for the S&P Small-Cap 600, it was. 20.82. Another valuation measure, return on shareholders’ equity (ROE), was 10.87 for the S&P 600, 20.97 for the S&P 500. ROE measures the profit a company (or the companies in an index) generates based on the money shareholders have invested in that company. The higher the ROE, the greater the profitability

Writing in the July issue of the journal of the American Association of Individual Investors, John McDermott and Dana D’Auria noted that small-cap stocks beat large-cap stocks on an annual basis only about half the time between 1926 and December 2013.

“While we are unable to forecast future returns, we can look at historical stock returns for evidence of a small-cap premium,” the authors said. “The well-known small-cap factor index called “SmB,” (small minus big) was created by professors Eugene Fama and Kenneth French to measure the performance of U.S. small-cap stocks relative to U.S. large-cap stocks. The annualized return of SmB from July 1926 through December 2013 is 2.22%, providing evidence for a small-cap premium. However, SmB is positive in only a little more than 50% of calendar years, evidencing that small-cap outperformance in any given year is far from a sure thing and more like the flip of a coin.”

In other words, to benefit from the small-cap premium, the asset class must be held for an extended period of time.

As we do each quarter, we are methodically reviewing client portfolio allocation among all the classes, small-cap stocks included, to determine whether rebalancing is in order. When actual exposure to an asset class deviates by a set percentage from its target, we rebalance, selling high-performing classes and buying low-performing ones.

A note: We believe the best way to capture the characteristics (risk and return) of an asset class is to invest in a low-cost exchange-traded fund. Mentor Capital client portfolios right now contain the iShares Russell 200 ETF (IWM), the Vanguard Small-Cap ETF (VB) and the Schwab Fundamental U.S. Small Company ETF (FNDA).