Investors often turn to small-cap stocks and the related exchange traded funds in an effort to access strong growth prospects. As such, on a valuation basis, the cost of admission with smaller equities is usually high.
That’s not the case at the moment. In fact, small-caps are unusually inexpensive relative to historical precedent , potentially enhancing the allure of ETFs such as the Invesco NASDAQ Future Gen 200 ETF (QQQS). According to a recent analysis by the Leuthold Group, small-caps trade a steep 25% to large-caps.
Add to that, small-cap equities are trading at 16x this year’s expected earnings while that ratio rises to 19x for big companies. That’s notable for long-term investors considering QQQS because history indicates the lower small-cap valuations when an investor gets involved, the better the probability of upside is.
“History suggests this tends to be cyclical. Small-caps go in and out of fashion. Kenneth French, finance professor at Dartmouth and part of the famous duo with Nobel laureate Eugene Fama, maintains data on this going all the way back to the mid-1920s. Over the very, very long term—in other words over the past 100 years—he estimates that the smallest 30% of companies on the stock market have beaten the largest 30% by an average of 5 full percentage points a year. To put this in context, that would produce twice the gains over 20 years,” reported Brett Arends for MarketWatch.
Conversely, small-caps can try investors’ patience if market participants embrace the asset class when valuations appear stretched when measured against large-caps. Fortunately, that’s not the case today, indicating opportunity could be plentiful with ETFs such as QQQS. There are other issues to consider.
“Hedge fund firm AQR estimates that any small cap outperformance has really been due to higher quality companies, meaning those with profits, stability and solid balance sheets,” according to MarketWatch.
While QQQS isn’t a dedicated quality ETF, less than a quarter of its 201 components are considered growth stocks — a relevant point because the small-cap growth space is littered with money-losing companies. That percentage is well below the 34% the fund devotes to value stocks, some of which are currently profitable.
QQQS debuted last October and follows the Nasdaq Innovators Completion Cap Index. More than 7% of its holdings are mid-caps, which is another segment trading at attractive multiples relative to large-caps.
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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.
