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Deep Dive: A bargain you can’t ignore: Small-cap stocks are trading at their second-biggest discount in 20 years

Small-cap stocks, as a group, are bargain-priced relative to more popular large-caps, but you may be surprised at just how cheap they are. And wait until you see their performance from similar valuation levels.

Look at this 20-year chart, which shows the weighted forward price-to-earnings ratio for the S&P Small Cap 600 Index
SML
versus the large-cap benchmark S&P 500 Index
SPX
:

FactSet

William Watts reported on what appears to be a breakout for small-cap stocks after eight months of relatively flat performance. That is based on the movement of the Russell 2000 Index
RUT.

In this article, we are focusing on the S&P Small Cap 600 Index, which is far more selective than the Russell 2000 because because most of its companies are profitable. Standard & Poor’s criteria for initial inclusion in the index includes positive earnings for the most recent quarter and for the sum of the most recent four quarters.

Aside from the early coronavirus pandemic doldrums of March 2020, the S&P 600 Small Cap Index hasn’t traded this low, relative to the S&P 500, in 20 years.

Here’s a breakdown of the relationship between current and average forward P/E ratios for the two indexes, using weighted data compiled by FactSet:

Forward price-to-earnings ratios

Index

Current

3-year average

5-year average

10-year average

15-year average

20-year average

S&P Small Cap 600

15.63

16.69

16.60

15.81

15.32

15.34

S&P 500

21.59

19.49

18.69

16.72

15.54

15.72

Valuation of S&P Small Cap 600 to S&P 500

72%

86%

89%

95%

99%

98%

The small-cap group typically trades much closer to the valuation of the large-caps than it does today.

Now take a look at a 20-year comparison of total returns for the two indexes:

FactSet

In an extended bull market, driven in part by historically low interest rates, it is understandable that the best-known stocks (the large-caps) have had the most benefit. But all of the above argue for adding exposure to small-caps for the long term, as part of a diversified portfolio, especially if you have a lot of money in an S&P 500 index fund or exchange traded fund.

For a shorter-term case, see this comparison of aggregate consensus 2022 estimates among analysts polled by FactSet for the two indexes:

Sales per share

2021

2022

Expected increase

S&P Small Cap 600

$1,170.21

$1,261.61

7.8%

S&P 500

$1,547.09

$1,650.78

6.7%

Earnings per share

2021

2022

Expected increase

S&P Small Cap 600

$82.41

$94.04

14.1%

S&P 500

$202.11

$218.74

8.2%

Free cash flow per share

2021

2022

Expected increase

S&P Small Cap 600

74.46

89.86

20.7%

S&P 500

171.63

195.76

14.1%

Good numbers across the board — but the estimates are higher for the small-cap group.

For both groups, the free-cash-flow estimates are comforting. Free cash flow is a company’s remaining cash flow after planned capital expenditures. It is money that can be used for expansion, dividend increases, stock buybacks or other corporate purposes.

How to get exposure to small-caps

If you are fortunate enough to have access to an employer-sponsored retirement account, the most important piece of advice anyone can give you is to contribute at least as much as your employer’s maximum contribution. If you do that, you have an immediate 100% return on your contributions.

Then you should look at the fees charged by the mutual funds available within the 401(k) or similar plan. Index funds, which typically have lower expenses than actively managed funds, may be available, and these may include a small-cap fund. Your plan may also allow you to put money into a brokerage account, within which you can select exchange traded index funds that also have low expenses.

Here are a few ETFs that track the S&P Small Cap 600 Index:

iShares Core S&P Small Cap ETF
IJR

SPDR Portfolio S&P 600 Small Cap ETF
SPSM

Vanguard S&P Small Cap 600 ETF
VIOO

Small-stock screen: Analysts’ favorites for 2022

Among the S&P Small Cap 600, there are 24 stocks with 100% “buy” or equivalent ratings that are each covered by at least five analysts polled by FactSet. Here they are, sorted by the 12-month upside potential implied by the consensus price targets:

Company

Industry

Closing price – Nov. 3

Consensus price target

Implied 12-month upside potential

QuinStreet Inc.
QNST

Advertising/Marketing Services

$13.44

$26.80

99%

Tactile Systems Technology Inc.
TCMD

Medical Specialties

$36.90

$69.25

88%

LendingTree Inc.
TREE

Finance/Rental/Leasing

$151.37

$238.75

58%

Talos Energy Inc.
TALO

Oil & Gas Production

$13.22

$19.25

46%

Cytokinetics Inc.
CYTK

Biotechnology

$36.67

$52.50

43%

Ichor Holdings Ltd.
ICHR

Semiconductors

$46.04

$60.40

31%

Ultra Clean Holdings Inc.
UCTT

Semiconductors

$55.35

$72.58

31%

Ligand Pharmaceuticals Inc.
LGND

Biotechnology

$159.96

$207.86

30%

Smart Global Holdings Inc.
SGH

Semiconductors

$56.22

$72.00

28%

TTM Technologies Inc.
TTMI

Electronic Components

$13.99

$17.79

27%

Vista Outdoor Inc.
VSTO

Recreational Products

$43.41

$54.89

26%

Harmony Biosciences Holdings Inc.
HRMY

Pharmaceuticals: Major

$42.93

$53.80

25%

Civitas Resources Inc.
CIVI

Integrated Oil

$53.89

$66.17

23%

Griffon Corp.
GFF

Building Products

$27.22

$33.33

22%

Korn Ferry
KFY

Personnel Services

$79.98

$97.75

22%

NeoGenomics Inc.
NEO

Medical/Nursing Services

$46.53

$56.45

21%

SPX Corp.
SPXC

Industrial Conglomerates

$62.09

$75.25

21%

LCI Industries
LCII

Miscellaneous Manufacturing

$149.50

$178.00

19%

Green Plains Inc.
GPRE

Chemicals: Specialty

$38.89

$45.89

18%

Digi International Inc.
DGII

Computer Peripherals

$23.13

$27.10

17%

Summit Hotel Properties Inc.
INN

Real Estate Investment Trusts

$10.44

$11.60

11%

Veritex Holdings Inc.
VBTX

Regional Banks

$42.75

$46.50

9%

Onto Innovation Inc.
ONTO

Electronic Production Equipment

$84.29

$90.20

7%

Axcelis Technologies Inc.
ACLS

Electronic Production Equipment

$59.04

$57.17

-3%

Source: FactSet

Click on the tickers for more about each company. Click here for Tomi Kilgore’s detailed guide to the wealth of information for free on the MarketWatch quote page.

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