Sector Now Trading at 19% Discount to Historical Average
Small-cap stocks are currently at their lowest valuation in 14 months, making them considerably cheaper than their large-cap counterparts, according to a BofA Global analyst note released last week.
While this doesn’t guarantee an immediate rebound in the battered small-cap stock prices, analysts at the bank suggest that it could signal the potential for better long-term returns, as stated in the client note.
Small-cap stocks have significantly underperformed large-cap stocks throughout the year. For instance, the Russell 2000, a small-cap benchmark consisting of the 2,000 smallest companies by market capitalization in the Russell 3,000, has experienced a year-to-date loss of 3.1%, in stark contrast to the 15% gain seen in the large-cap benchmark S&P 500 and the 32% return of the tech-heavy Nasdaq Composite, according to FactSet data.
With the recent equity selloff, the price-to-earnings ratio of the Russell 2000 has dropped to 12.3, marking a 14-month low, as reported by BofA Global. Comparatively, small-cap stocks continue to be the most attractively priced by market capitalization, trading at a 19% discount to historical averages. In contrast, midcap stocks are trading at a 4% discount, while large-cap stocks are trading at a 12% premium to historical averages. Megacap stocks, represented by the Russell Top 200, are trading at an 18% premium, according to BofA Global’s data.
Looking ahead, the price-to-earnings ratio of the Russell 2000 implies an annualized return of 12% over the next decade, compared to a 7% annual gain for the Russell 1000, as highlighted by the analysts.
It’s important to note that the relatively low valuation of small-cap stocks may not necessarily translate into an immediate price increase, as valuation is typically a less reliable indicator for short-term timing.
BofA analysts note that it’s more likely over the long term.
The Russell 2000 Index — the world’s most closely followed gauge of small caps — rose over 5% last week as softer US inflation data bolstered bets that interest rates have topped out. Still, it will be hard for the index to avoid posting its worst year since 1998 against a benchmark of larger peers, given how vulnerable it is to damagingly high debt costs and the potential for economic downturn.
Bloomberg seemed to echo that sentiment, warning yesterday that the powerful rally in small-cap stocks looks like a false start rather than a lasting recovery.