Mind the Gap in Small- and Large-Cap Valuations
Having previously examined small caps’ valuations relative to their profitability and long-term EPS growth forecasts and the relative valuations of equities and bonds, we now turn our focus to small caps’ valuations relative to their larger peers.
Small-cap stocks, as measured by the MSCI USA Small Cap Index, have underperformed large- and mid-cap stocks, as measured by the MSCI USA Index, by about 35% over the last five years and by roughly 10% this year, both periods ending Sept. 30. This has led to unusually low valuations for small caps.
Small caps’ relative-value role reversal
Over the last 15 to 20 years, small caps in aggregate have generally been more expensive than large- and mid-caps on a forward price-to-earnings (P/E) basis, but cheaper on a price-to-book (P/B) basis.
Since Q4 2021, however, the MSCI USA Small Cap Index has had a lower forward P/E than the MSCI USA Index. As of Sept. 30, the forward P/E stood at 17.0 (which corresponds to the 20th percentile of values since June 2008) and 18.4 (80th percentile of values over the same period), respectively.
On a P/B basis, the valuation spread between the two indexes is now at its largest since March 2003. And since March 2021, based on the same metric, the average small-cap stock has been consistently cheaper than the cheap large and mid-caps.
While the price behavior of the “Magnificent Seven” has contributed to this widening valuation gap, we cannot know, of course, how long these unusual valuation relationships between small and large caps may persist. The gap could expand further as small caps grapple with high interest rates1 or the current environment may even represent a new normal. Whether either of these futures unfolds, or if better days are on the horizon for small caps relative to large caps, remains to be seen.
Small caps have had a lower forward P/E than large caps since late 2021
The average small cap has been consistently cheaper than larger caps since 2021
1 Ethan Wu, “US small-cap stocks wilt in the heat of higher interest rates,” Financial Times, Sept. 27, 2023.
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