Typically, small-cap companies have higher growth rates and potential, are more cyclically sensitive and tend to lead large caps in performance during economic expansions. Although global economic growth is below trend, leading indicators are pointing to a rebound in many of the major developed markets. This optimism is evident in the performance of the small-cap equity markets year-to-date.
Investors have a tendency to get overly enthused about growth prospects, which means that they tend to overpay for this potential growth. As a result of the increasing optimism and recent performance, we believe that valuation risk is one of the single greatest risks to current portfolio allocations in the small-cap space today.
Apart from the price-to-earnings ratio, another way to measure if investors are paying too high a price for the underlying fundamentals is the price-to-dividend ratio . In the chart below we will look at the 10-year price-to-dividend ratio of different regional indexes.
• When price growth equals dividend growth, there is no change in the price-to-dividend ratio—as dividends didn’t become any more or less expensive relative to the price.
• When dividends grow faster than the price—there are greater amounts of dividends per unit of price—the price-to-dividend ratio drops, which reflects the markets getting cheaper.