No. of Recommendations: 39
The problem with US small caps these days is that they aren't the same quality of company that they used to be.A few notes just briefly.
If you are worried about many of the small caps not profitable, you can purchase the S&P600 small caps index (say IJR) in which all firms you own are profitable both the last quarter and the last year, by definition of the index.
Margins for profitable small caps have been lower than the large caps the last 20 years.. that may lead us to assume they are more like junk. But do not immediately jump to the conclusion that the lower margins implies a lower quality. The far lower margins of the S&P600 (averaging 5% last 20 years, and today at 6%) have come also with faster growth than the large caps (more effective capital expensive or just better opportunities to use sales to fund growth, thus the Lower margins).
Small caps growing faster than large caps is probably shocking for many to hear right now - with AI excitement in the air. We imagine large caps as a whole growing faster especially these last two decades. But much of that growth isn’t the IV growing, so much as multiple expansion (ie. Wall St enthusiasm growint) with the multiple expansion concentrated to the large caps (not just the insanely large tech firms but the S&P500 as a whole).
Small caps have outperformed large caps by revenue at a rate of 2% annually even over these last 20 years. And very similar to this 2% over the much longer past.
There is a narrative going around Wall St that small caps are hit hard from having more debt and a consequently higher interest charges hitting earnings. But this seems to be just that - a story going around, as I do not see it in the analysis of margins. They have already recovered and are even today higher than usual, as stated further above.
It is good to compare the price of small caps today compared to ten year average real earnings. On this basis the S&P600 small caps are priced exactly at their own 20 year average valuation range.
If the firms just continue to grow EPS at their usual average rate and just sit at the present earnings multiple (right now the PE is 15, just a little below where they usually trade) with the squiggles ignored between today and an end point ten years away, and just measuring from here to there - then one will have a return of the EPS growth plus the dividend. Historically that has been about 8.5% real. The last 20 years pretty similar at 11.5% nominal (the EPS growth 10%).
This greatly contrasts what we could (as a central estimate) expect from large caps, with both rhe EPS growth 2% less than small caps, and on top of that some near-certain serious multiple compression as we are starting at a CAPS ratio almost double their own norm, for large caps, versus the S&P60@ small caps’ CAGR still sitting at its own long term average level.
It is true that in the short term (5 years or less), all stocks are pretty highly correlated. Yet note that from the high of the March 2000, small caps really became disentangled from the laege caps. The small cap S&P600 returned 75% versus minus 15% for the large caps:
https://bigcharts.marketwatch.com/advchart/frames/...- Manlobbi
