Small-caps: Fueled up but pricey

With a gain of more than 28% from the start of the year, small-caps have outperformed large-caps by 8 percentage points.

Based purely on recent performance, one could easily conclude that small-capitalization stocks might have run a little too far, too fast — that is, if we weren’t talking about small-cap stocks.
Amid a government shutdown, fiscal-policy gridlock, five years of quantitative easing and a barely registering economic recovery, there is no reason to think that small-cap stocks won’t continue to rally.
Granted, with a gain of more than 28% from the start of the year, small-caps have outperformed large-cap stocks by 8 percentage points. And on a total-return basis from the March 2009 market bottom, small-caps, as measured by the Russell 2000 Index, have gained 229%, which compares with a 173% gain for the S&P 500.
Higher-beta stocks
The fuel for all that small-cap performance is obvious and predictable.
It follows the logic that smaller, more nimble companies typically lead the way out of economic downturns. They also tend to be higher-beta stocks, so they participate more easily in broad market movements.
But even after such an extended period of pronounced leadership, there still could be more momentum in the form of increased mergers-and-acquisitions activity, which generally favors smaller-company stocks.
Until the financial crisis, there was a strong correlation between small-cap-stock performance and M&A activity. Deal volume peaked along with the equity markets in late 2007 and then dropped in stride to the March 2009 trough.
But while we know what stocks have done since that point, M&A activity has remained relatively flat until recently.
“When times are scariest, no one wants to think about doing M&A deals, because they’re just thinking about surviving,” said Nathan Moser, manager of the Pax World Small Cap Fund (PXSCX).
Even though the most extreme fears that followed the financial crisis have mostly dissipated, the rolling pattern of geopolitical and global macroeconomic challenges has slowed the pace of M&A activity.
From a peak of $1.2 trillion worth of M&A volume in the fourth quarter of 2007, the post-crisis quarterly volume has hovered in the $500 billion range.
To small-cap investors, this slowdown should represent potential fuel for the category.
For starters, smaller companies represent an overwhelming majority of acquisition targets. Of the 4,020 M&A deals completed over the past five years, 3,352 involved companies with market capitalizations of less than $1 billion. Increasing the market cap limit up to $5 billion captures 3,906 of those 4,020 deals.
Thus, while impressive — small-cap performance could have some investors taking money off the table — even a slight reversion to the mean could easily add another leg to the current small-cap run.
“You don’t have to have M&A activity come all the way back, because that would be a doubling of the current activity,” Mr. Moser said. “But we’re already seeing a pickup.”
P/E ratios
Clearly, not everyone is going to subscribe to the theory that there is fuel left in the small-cap tank.
Citing a price-earnings ratio of 30 for the Russell 2000, compared with a P/E of 16 for the S&P 500, Aaron Izenstark, chief investment officer at Iron Financial LLC, said: “We think small-caps are overextended here.”
“It’s hard to make the case for more of the same kind of performance unless we get some significant growth in the economy,” he added.
Seth Reicher, president of Snyder Capital Management LP, said that in a “momentum-oriented market like this, the stocks that have done well continue to do well, but there is no free lunch, and it just gets riskier from here.”
“If you’re bullish on the overall market, you will want to be in small-cap stocks, but keep in mind that anything that moves 25% or more is vulnerable to a correction,” he added.
“Investors are asking for growth,” Mr. Moser said, “and that’s where companies will start looking to grow through M&A.”