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I heard that small caps are the cheapest they have been in 25 years. When that happened, small caps tripled in value, while the s and p stayed flat for the next 7 years. Their p/e is about 10, while the markets p/e is about 23. AVUV is a good small cap value fund.

Here is a recent article on the best small cap ETFs if you are interested. Manlobbi's post to consider small caps was what prompted this so I will also post on the Index Investing board.

https://www.morningstar.com/funds/best-small-cap-e...

I heard that small caps are the cheapest they have been in 25 years.

Though they may (or may not) be cheaper than usual, it's likely that the comment would be primarily along the line that they are the cheapest they have been relative to the valuation level of large caps. That changes the implied optimal investment strategy.

Jim

Though they may (or may not) be cheaper than usual, it's likely that the comment would be primarily along the line that they are the cheapest they have been relative to the valuation level of large caps. That changes the implied optimal investment strategy.

Are you saying they aren't cheaper than usual? How does it change the implied optimal strategy?

Though they may (or may not) be cheaper than usual, it's likely that the comment would be primarily along the line that they are the cheapest they have been relative to the valuation level of large caps. That changes the implied optimal investment strategy.
...
Are you saying they aren't cheaper than usual? How does it change the implied optimal strategy?


No, I was explicitly avoiding that question of whether small caps are cheaper than their own historical average. My point is that there are potentially different situations:
* If small caps are cheap (and as good an investment as they were historically) then they're probably a buy.
* If they are merely cheaper than large caps (and as good an investment as they were historically) but both are expensive, then probably neither is a good buy.

The problem with US small caps these days is that they aren't the same quality of company that they used to be. This is a very interesting article outlining the observation, though probably behind a paywall. Maybe try searching "Small stocks big problems".
https://www.ft.com/content/abfbf19e-f963-4c1b-b69e...

Some observations from that: in 1995 only about 5% of small caps had negative forward earnings, now it's about a third.
The median ratio of gross profits to assets has fallen from around 29% to around 19%. (excludes healthcare, so as not to impose an undue penalty for more common profitless biotechs)
The balance sheet is worse: debt to earnings has risen from around 2x to about 3x.
There is a whole lot of small cap junk, very much more than was historically typical.

One possible narrative explanation is that all the reasonably decent-looking smaller firms have been snapped up by private equity or been acquired by bigger fish...only the less desirable up-and-comers have gone public.

I tend to think of the market as being made up of small caps, large caps, and a tiny number of truly gigantic firms. Ignoring the giants for a moment, the large caps are generally better businesses than the small caps, especially in recent years, so if the small caps are lagging them in market performance then that is not necessarily a buy signal for small caps. The giants (which dominate the S&P cap weight) are so few in number that they aren't statistically predictable one way or the other, even though they are the ones that determine whether the S&P 500 is leading or trailing lately. So any size comparisons with potential predictive power should probably leave those out. e.g., compare the Russell 2000 to the S&P 490 or to the S&P 500 Equal Weight.

Jim

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

Manlobbi, does your enthusiasm for small caps indices, combined with you no more posting on the Manlobbi board mean you turned away from picking stocks with your method ("IV10") of which your board was all about?

Thanks for the post, Manlobbi, but I still have my doubts.

My concern is not so much that the small caps are unprofitable (though there is plenty of that out there), but more generally that on average they are not nearly as high quality businesses as small caps used to be, and of course not as profitable as large caps in general. They aren't as profitable as businesses in the sense that they don't have the same return on assets or equity, and they are more fragile in that they are running with higher gearing than they used to. They may or may not be a good class to be in at the moment in terms of forward price returns, and the outlook for the S&P 500 is not great so it may make an easy comp, but I don't think that the historical US small cap results are going to give us a reliable answer on that because things have changed. The biggest issue is the big increase in the share of aggregate value added going to the top 2-3 companies in almost every industry. The long tail is now that of a mouse, not that of a T-rex. I would not base any investment decisions foursquare on historical rates of growth among the tiddlers, nor on mean reversion between indexes.

You mention faster growth, but which metrics are you looking at? And is that the historical rate of growth of the index including past eras when the quality of firm was better? i.e., is there any reason to think that *today's* small caps have growth rates on average higher than those of larger firms?

I haven't done that study as I don't have the data here myself, but I'm dubious anyway : ) Dubious that they are [now, especially] a place to find higher typical growth in metrics correlating with value. Though it's not the same thing because it misses the other S&P600 index criteria, I note that the median 5-year sales growth among those stocks currently in the S&P600's market cap range is 2.5%/year lower (not higher) than the median among S&P 500 members. EPS growth 2.0%/year slower. Ten year rate gaps in the same direction but a tad smaller gap.

Times are very tough for small firms, many have run up too much debt, and many of the minority that were prospering anyway have been acquired. The average attractiveness drops rapidly if the upside outliers are removed.

Jim

You mention faster growth, but which metrics are you looking at?

I was looking at everything together except the index quotation which will lead you to the wrong conclusion. Main two are revenue growth compared between the two indexes as a proxy for their relative rate of actual value increase (this doesn't work well for stocks but is useful when comparing two indexes), or the total IV increase by means of adding the dividend onto the EPS growth and normalising for margins. It is true that the margin expansion of the S&P500 can be interpreted as part of a sustainable value increase, but I discuss that further below.

In my post I cited revenue growth of the small caps exceeding large caps by 2% over the multi-era long-term, as well as the medium-term (20 years). EPS growth of the small caps was 10% the last 20 years, or 11.5% with the dividend.

If we look at only the very recent period, let's say revenue growth from the start of 2018, not much changes - since 2018 small caps and large caps both grew at the same level of around 52%. There was a big speedup for small caps as covid was coming to an end, and then slow down afterwards, but it averages out. The temporary low margins of small caps, which is fairly often discussed on Wall St when small caps come up is cited as related to the higher debt - however those low margins have already recovered. Margins for small caps sit at 6% today versus their 5% average the last 20 years. So earnings aren't actually depressed at all.

If we look at EPS, and projecting what will happen to EPS from today, I firmly caution that it is less wise to project EPS for the large caps because such a projection requires large cap margins to continue to grow as they have in the past. So for purposes of comparing EPS between two indexes, even if you don't assume any mean reversion at all, you at least have to cancel the requirement that margins continue to expand further from here. That in itself cuts the EPS projection down enormously for the large caps. In short, just use revenue projections when comparing two indexes. Small caps recently grew revenue at the same rate as large caps, over the last 20 years (medium-term) they grew 2% faster, and over the longer term they grew 2% faster.

In summary, all of the perceived outstanding performance of the S&P500 large caps over those 20 years since 2004 is essentially taken from (1) EPS multiple expansion, and (2) margin expansion.

This can very easily lead us to the incorrect conclusion that small caps are in some way inferior companies as a group. This simply does not match the data, even if it sounds natural and intuitive right now. It will have sounded also intuitive in March 2023 when there was a view that they were old-school, and the next 5 years the small caps quotations rose 75% in 5 years versus -15% for the large caps.

Let's look at 1 and 2 and compare the variables between the large caps and small caps, regarding what to expect from today. I mean the two independent variables: (1) EPS multiple expansion, and (2) margin expansion. Keep in mind, in the comments that follow, that small caps are likely to grow revenue at a higher rate than the large caps (S&P500) or at least the same rate. We're just looking at only other two independent variables that lead to the relative outperformance.

For the S&P500 large caps, the first of these (valuation multiple) is very high. The CAPE ratio of the S&P500 is 37 versus 26 average the last 20 years, which is 42% too high. If the multiple merely remains at the current high level without falling, then the rate of change in the multiple will collapse, so stock price returns will be lower than we are used to even if the EPS continues to rise at an average pace we have become used to. But EPS is unlikely to keep rising for another, reason - margins, which gets us to the second variable. For the second variable (margin expansion) we can be optimistic and just assume that they will simply stop continuing to expand. In this optimistic scenario, the *rate of change of margins* over the last decade will fall from the present high positive number down to zero - just to sustain the present margins. This would cause the EPS growth in the large caps to be much lower than we have grown accustomed to observing. So there are two separate downwards forces (multiples, and margins) forces on stock prices for large caps, and one relative upwards force (revenue growth).

For the S&P600 small caps, the first of these (valuation multiple) is at its average level of the last 20 years whether measured by the CAPE ratio of the S&P600 or the one year PE. The forward PE of the S&P600 is 16 today versus, 17 average the last 20 years. I presented a chart of the S&P600 CAPE on the Index Investing board. The CAPE ratio is right in the middle of its own 20 year range for at the S&P600. This PE is itself is based on not particularly high margins, unlike the PE of the large caps which is based on (possibly) temporarily high earns. Now onto margins, small caps are now at 6.5% versus their 5.5% 20-year average.

They [small caps] may or may not be a good class to be in at the moment in terms of forward price returns, and the outlook for the S&P 500 is not great so it may make an easy comp, but I don't think that the historical US small cap results are going to give us a reliable answer on that because things have changed. The biggest issue is the big increase in the share of aggregate value added going to the top 2-3 companies in almost every industry.

This is reflected in, or highly overlapping with, the observation of higher margins today in the S&P500. They key point there is that this advantage has already taken place - margins have already expanded, and can't continue to expand from here at that same rate. To address this question above, one can also ignore the subject of margins, and separately argue that a few mega huge firms, such as Google, will continue to grow at an outstanding rate by having superior abilities to suck up earnings from other firms. However this also doesn't match the data, for the small caps grew revenue at a faster rate than large caps the last 20 years (which view as a medium-term period) which includes the last few years of (at least for now) heightened monopoly-acceptance. Small caps also grew revenue at the same rate as the large caps the last 7 years (obviously with sub periods within those 7 years sometimes higher for one, sometimes higher for the other).

In summary, you can track 3 separate variables - revenue growth, change in margins, and change in valuation multiples, when comparing two indexes. These 3 variables combine together to get the change in stock price. Normally only 1 or 2 of the 3 might win, and the story to be far not determined, but we have a case that 3 out of 3 win for the small caps when looking at what to expect from today.

In short, the small caps feel like lower quality firms (to an investor projecting either the rate of increase in revenue into the future), or an investor projecting the growth in EPS forward into the future), because of the existing narratives and the poor stock price performance. However that intuition does not match the actual data, even when no reversion to the mean arguments are used.

- Manlobbi

Manlobbi, does your enthusiasm for small caps indices, combined with you no more posting on the Manlobbi board mean you turned away from picking stocks with your method ("IV10") of which your board was all about?

Yes, I very happily use the 'Manlobbi Method' for pretty much all my savings, which requires the investment to be (1) Steadfast followed by (2) maintaining very concentrated high IV10/price allocations, and (3) switching capital from the lowest IV10/price situations to the higher IV10/price opportunities. Your long-term return is already likely to outperform the market just from 1 and 2 (if just holding) but the benefit of 3 causes the outperformance to be a little higher again.

Index ETFs are just one possibility as to what one might evaluate as Steadfast and then go on to calculate the IV10/price ratio for. Index ETFs are, very nicely, Steadfast by definition - it obviously not possible for all firms to go bankrupt at once, so you are really just faced with temporarily price collapses from valuation multiple collapses, which the method doesn't try avoid. It partly avoids it inherent because when an index has a high IV10/price ratio, compared to other indexes, then almost by definition the valuation of the index will be cheap at the time so multiples won't have so far to collapse (the index already trading at, near, or below its own average valuation multiples, particularly after normalising the earnings for changing margins).

The Manlobbi's Descent board was popular at TMF, but I never really even started to post on the Manlobbi's Descent board at Shrewd'm since simply for lack of time, and a higher priority to help momentum/culture with the other boards. I may post my holdings and reasonings there occasionally.

- Manlobbi

IJR up 6% today, 7.62% last 5 days. Finally catching up to the big boys.

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