Why You Should Be Wary of Small-Cap Stocks

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By Steven Goldberg

Stocks of small companies have defied gravity for years now. From the bottom of the bear market on March 9, 2009, through Feb. 14, the Russell 2000 index of small-capitalization stocks has returned an annualized 29.5 percent, trouncing the large-company-oriented Standard & Poor's 500 stock index by an average of 4.4 percentage points per year.

What's more, the Russell 2000 (^RUT) has beaten the S&P 500 (^GPSC) every year since 1999, except for 2005, 2007 and 2011. Over that stretch it has returned an annualized 8.2 percent, compared with 4.7 percent for the S&P. That's the longest run of market-beating returns for small caps ever -- far eclipsing the old record set from 1973 to 1983.

But that huge outperformance has made small caps "extremely overvalued" in the view of Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch (BAC). "This is the upper bound of absolute valuation," he says. (Biotech looks even more problematic; more on that in a minute.)

Small caps are about as expensive as they've ever been. Their price-earnings ratio -- based on operating earnings over the past 12 months -- is 23 percent greater than the P/E of the 300 largest U.S. companies, reports the Leuthold Group, a Minneapolis-based investment research firm. That premium is the second-highest since Leuthold began tracking the measure in 1983. (It was slightly higher in 2011).

Just look at the numbers. The 300 largest companies trade at a bit less than 16 times estimated 2014 earnings. In contrast, small caps -- which Leuthold defines as stocks with a market value (share price times number of shares outstanding) of less than $3.3 billion -- trade at an average price-earnings ratio of just under 20.

What could spark a sell-off? DeSanctis voices several concerns aside from valuation. First, the small-cap earnings reports in the fourth quarter were "sloppy," he says. %VIRTUAL-article-sponsoredlinks%Year-over-year earnings growth has been a robust 12 percent, but more companies than usual have reported earnings below analysts' estimates.

Second, he thinks the Federal Reserve's tapering of its bond purchases will lead to greater volatility in the stock market. "The pickup in volatility is bad for small caps," he says.

Third, DeSanctis says, analysts are wildly over-optimistic about earnings for the coming 12 months. On average, analysts predict that small-cap earnings will rise 20 percent, he says, but those forecasts are "very unrealistic." He estimates 12 percent earnings growth. When companies report disappointing earnings, the market almost always punishes their stocks.

Fourth, bargains in small-cap land are scant, DeSanctis says. "Every stone has been overturned." Only 10 percent of the stocks in the Russell 2000 sell for less than 10 times estimated earnings.

Companies in the Russell without earnings -- which represented 12 percent of the index's market value -- led the index last year, an event DeSanctis calls "awfully strange." Anytime speculative stocks lead the market, you should be concerned. Just a bit more than one-third of the firms with no profits were in health care, mainly biotechnology.

Small-cap biotech stocks have soared 72 percent from the start of 2013 through Feb. 17. Many, if not most, of these companies expect to remain unprofitable for years to come, are looking for more financing and have just one or two compounds in the early stages of testing. Most such compounds never even get close to being approved for sale. and if they do get regulatory approval, the process can take years.

These biotech stocks trade at an average of 27 times revenues -- that's revenues, not earnings. That's about 50 percent more than average. The only time they were more richly priced was just before the popping of the tech bubble in 2000.

The biotech industry may be approaching a turning point in drug development, and biotech companies are targeting major diseases, including cancer, dementia and heart disease. But as we learned during the tech meltdown, even if you invest in a company that is changing the world, you stand a good chance of losing money if you pay an insanely high price for its stock.

Steve Goldberg is an investment adviser in the Washington, D.C., area.


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Why You Should Be Wary of Small-Cap Stocks

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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