With the equities market pushing forward, some are beginning to grow cautious on small-capitalization stocks and related exchange traded funds that reveal frothier valuations, potentially capping further gains.
For example, the iShares Russell 2000 ETF (NYSEArca: IWM) has a 18.6 price-to-earnings ratio, iShares Core S&P Small-Cap ETF (NYSEArca: IJR) has a 18.7 P/E and Vanguard Small Cap ETF (NYSEArca: VB) has a 19.2 P/E. In contrast, the SPDR S&P 500 ETF (NYSEArca: SPY) shows a 17.3 P/E, according to Morningstar data.
Despite falling behind large-cap shares in 2014, fund managers and analysts are warning that small-cap stocks are trading at valuations above long-term averages, reports David Randall for Reuters.
Steven DeSanctis, an analyst at Bank of America Merrill Lynch, believes that Russell 2000 companies look expensive relatively to historical averages as the trailing price-to-earnings ratio of the Russell 2000 hovers around 22.7, or 40% more than its long-term average of 16.2.
“Small-cap companies have something of an advantage in this economy. But investors have figured that out,” Phil Orlando, chief equity strategist at Federated Investors, said in the Reuters article.
Due to the recent bounce in small-caps, DeSanctis argues that the high valuations could cut into returns.
Nevertheless, some like Steven Raineri, the lead portfolio manager of the Franklin All-Cap Value fund, are adding onto small-cap positions, anticipating that improvements here at home could bolster the small-cap category.
For instance, most smaller companies are not exposed to foreign exchange risks and the strengthening dollar. According to Bank of America Merrill Lynch, 81.3% of revenue from the Russell 2000 Index is generated within the U.S., whereas 64.3% of revenue for S&P 500 companies come from the states.
As an alternative to small-cap blend ETFs, investors can take a look at the value style to capture relatively cheaper plays. For example, the Vanguard Small-Cap Value ETF (NYSEArca: VBR) has a 16.2 P/E, iShares S&P Small Cap 600 Value Index (NYSEArca: IJS) has a 17.1 P/E and iShares Russell 2000 Value Index (NYSEArca: IWN) has a 16.5 P/E.
For more information on small-capitalization stocks, visit our small-cap category.
Max Chen contributed to this article. Tom Lydon’s clients own shares of IWM and SPY.