September 28, 2014

ETF P/E Ratios: Are Small Caps Overpriced?

There's been a lot of talk over the past couple of years about how small cap stocks are overpriced relative to large caps. Since the market bottomed in early 2009, the smaller end of the market cap spectrum has comfortably outperformed the S&P 500, returning about 253% and 208% respectively. After such a strong run, many have been left to wonder if it's time for large caps to shine again like they did for large stretches of the 80s and 90s. Indeed, since 2014 began, the Russell 2000 and the S&P SmallCap 600 have both fallen around 2.5% while the S&P 500 is up nearly 9% for the year, indicating reversion to the mean could be well underway.

So what's the best way to determine if small caps are indeed overpriced? We'd all be rich if it was that easy to predict, but P/E ratios seem to be the preferred method of many a pundit. And even that one metric can be calculated in numerous ways, looking at forward earnings, trailing 12 months, and so on. No matter how you calculate it, however, P/E doesn't seem to have all that much predictive power (particularly over the short-term). At best, the Shiller P/E (which looks at average inflation-adjusted earnings over the past 10 years) correlates very little with the next year's returns. Over 10 years, the r-squared for the Shiller P/E is 0.43, still leaving a lot to be desired.

Let's just assume, for a moment, that P/E ratios are valuable for making investment decisions. Looking at Morningstar forward-looking P/E data for iShares large, mid, and small cap ETFs, we see:
  • S&P 500 Large Cap (IVV): 17.51
  • S&P 400 Mid Cap (IJH): 20.69
  • S&P 600 Small Cap (IJR): 20.67
Wheel of Fortune, Price-to-Earnings Ratio
Interestingly, mid and small caps appear to be priced roughly equally based on P/E alone. If we assume all three should be roughly equal, small caps are about 18% more expensive than they should be. But that includes a lot of ifs. If earnings grow at the same rate for all three segments, most importantly.

What about other ratios? The Fama-French three-factor model uses price-to-book to determine what stocks fall into the value category. It's tough to make much of an argument for large value stocks outperforming large growth over time, but Fama-French found that the small value premium has been persistent over time. That said, let's look at P/B ratios for the same three ETFs:
  • S&P 500 Large Cap (IVV): 2.43
  • S&P 400 Mid Cap (IJH): 2.23
  • S&P 600 Small Cap (IJR): 2.02
Now small caps look significantly cheaper, with large caps appearing to be 20% more expensive. I'm not sure what P/B ratios have been historically for small and mid caps, but the S&P 500 looks reasonable based on the past 15 years or so. Perhaps goodwill is more valuable for large companies with well-known brands? I'm really not sure, but small caps don't look expensive by this measure.

Next, let's take a look at price-to-sales. P/S probably isn't all that useful to compare individual stocks. Most investors would probably much rather invest in a smaller company with huge profit margins rather than a bigger company (from a revenue standpoint) that operates on razor-thin margins. But it's a pretty interesting ratio to evaluate ETFs, when each fund holds hundreds of stocks. On average across a large sample size it might tell you something. So how about the P/S ratios:
  • S&P 500 Large Cap (IVV): 1.74
  • S&P 400 Mid Cap (IJH): 1.27
  • S&P 600 Small Cap (IJR): 1.16
Again we have another metric to murky the waters further, with large caps looking more expensive relative to mid and small caps. On the flip side of that, price/cash flow looks more favorable to large caps (similar to P/E) with the bigger companies looking more affordable. As if that weren't confusing enough, sales growth rates for mid and small cap stocks are predicted to be slightly higher than large caps (about 4% vs 3%) but cash-flow and book-value growth is anticipated to be higher for large caps.

In other words, I have no clue if small caps are overvalued relative to large caps. The talking heads may insist upon it, but I don't believe there's enough convincing evidence to definitively suggest that companies with large market cap sizes will outperform any other cap size over the next few years. As a whole, if you believe the market P/E ratio tells you something, we're a bit on the high side in comparison to historical values. If you think the Shiller P/E is more valuable, then the market could be really overpriced. But in terms of one asset class category outperforming, that seems like a gamble at best.

This is just my opinion. As always, consult a financial professional and do your own research at multiple sources before making any investment decisions.

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