Small-cap stocks usually aren’t inexpensive. Throw in an environmental, social, and governance (ESG) overlay, and that price of admission can increase.
Interestingly, those factors aren’t at play today. Actually, small-cap stocks, including those with favorable ESG traits, are attractively valued at the moment. That could direct attention to exchange traded funds such as the SPDR S&P SmallCap 600 ESG ETF (ESIX). The extent to which small-cap equities are currently undervalued is dramatic.
“For smaller-company stocks, price/earnings ratios—a widely used measure for determining the value of a stock relative to its earnings—have reached their lowest levels in two decades. Lower ratios generally represent more attractive values and with a greater potential for price gains,” wrote Morningstar analyst Lauren Solberg.
Adding to the allure of small-caps is the fact that the group is outperforming large-caps in 2022. The S&P SmallCap 600 Index — the parent benchmark for ESIX’s underlying index — is beating the S&P 500 by 250 basis points year-to-date, suggesting that investors don’t have to embrace excessive valuations to gain access to outperformance. Actually, that outperformance can be had at a discount.
“The trailing 12-month price/earnings ratio for the Morningstar US Small Cap Index—a collection of the smallest 7% of U.S. stocks, each with current market caps of no more than $18.7 million—currently lies at 12.6, while the large-cap index’s price/earnings ratio is 20.2. A gap this wide between large- and small-cap valuations hasn’t been seen since 2002,” added Solberg.
An obvious reason why some ESIX member firms are attractively valued today is that many market participants believe the U.S. economy is in a recession or getting close to one. Small-caps are more sensitive to economic data than larger companies.
Conversely, the strong dollar and better earnings growth are among the tailwinds that small-caps and ESIX offer investors. Even if the dollar weakens in 2023, as some analysts expect it will, earnings growth could support the case for ESIX. That superior earnings growth can be had at a discount relative to large-caps, and there’s something to be said for accessing better earnings growth at a discount.
“But valuations on large stocks were much higher by historical standards heading into the bear market than on small-cap stocks, and their price/earnings ratios still haven’t hit historical lows. In addition, small caps lagged far behind big-company stocks during the 2021 rally and headed into the bear market with lower valuations,” concluded Solberg.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.