U.S. small-cap stocks have been on a tear this year, reaching new peaks and raising concerns that a major pullback may be imminent.
The Russell 2000 Index, which measures the performance of U.S. small caps, hit an intraday record high of 869 points on Monday before finishing at 855. The large-cap S&P 500 index, which closed yesterday at 1,361 points, is well off its record of 1,565 in 2007.
"U.S. small caps are priced for perfection," suggested Jack Ablin, chief investment officer of Harris Private Bank in Chicago. "I am relatively bearish … I would prefer U.S. large caps and international small caps."
With the weakening U.S. dollar, "U.S. large caps should do better than small caps because they tend to be exporters, while small caps, if anything, tend to be importers," Mr. Ablin said. "I think this continued slide in the dollar advantages the large-cap companies that are, at the same time, cheaper."
The Russell 2000 Index is trading at around 22.4 times one-year forward earnings compared with 13.2 times for the S&P 500, according to UBS.
The price-to-earnings ratio of the Russell 2000 is also at a record high of 1.34 times that of the P/E of the market's top 200 companies as measured by Russell Indexes, noted Lori Calvasina, director of small-cap equity strategy at Credit Suisse in New York.
The ratio was close to that level in June, 2007, when small caps started to weaken, Ms. Calvasina recalled. "I think we are sorely overdue for a pullback in small caps, but identifying the catalyst has proven rather difficult."
Ms. Calvasina is "cautious" on small caps and expects they will underperform their larger peers this year.
Small caps were outpaced by large caps for 18 months from mid-2007 through 2008, she said. "We need to expect shorter cycles between large caps and small caps going forward. The 2007-08 period is a taste of this and what's yet to come."
Other market observers argue that the small cap rally still has legs.
UBS strategist Jonathan Golub is still bullish, saying he doesn't believe small-cap valuations are stretched because their growth rates are "much higher" than those of large-cap stocks.
"The margins of large-cap companies have recovered more quickly from the downturn, and are close to peak levels," while the margins of small caps are well below their peaks, Mr. Golub said.
"If you have a company that is expected to grow by two or three times faster over the next two years, those extremely high valuations are not that unreasonable," he said. "Over the entire recovery cycle … small-cap companies have consistently surprised on their earnings announcements more than large companies have."
Takeovers of smaller outfits by large-cap companies flush with cash are also driving valuations, Mr. Golub said. "The pace of M&A should continue to improve over the next couple of years as well."
Jim Furey, chief investment strategist at Newport Beach, Calif.-based Furey Research Partners LLC, expects the bull market for U.S. small caps to continue for the next decade, although pullbacks of as much as 10 per cent are possible. He predicts the Russell 2000 will reach 1,000 this year.
"The single best predictor of small-cap relative outperformance is the level of financial stimulus in the economy," said Mr. Furey, who runs a small-cap strategy boutique. Real, or inflation-adjusted, interest rates should remain low, encouraging risk taking and investment "to grow the economy out of its hole and allow consumers and governments to service their debt," he said.
"Money will move from the bond market into the stock market as the Fed pursues a policy that promotes inflation and people's risk appetite improves," he said.
Matthew Beckerleg, a U.S. small-cap portfolio manager with Montreal-based Pembroke Management Ltd., agrees the backdrop is still favourable for U.S. small-cap stocks, and says that he is looking for companies that can grow regardless of the economic environment.
"We try to identify companies where there is a big green-field opportunity for them to become larger because they offer a new service or a new product that customers didn't have or that customers want," said the co-manager of GBC American Growth fund.
"If the company can continue to deliver a high return on capital and can continue to deliver a high level of profitable growth, eventually that will be reflected in the stock price."
Stock picks from Matthew Beckerleg, who co-manages the GBC American Growth Fund
Amerigon Inc. (ARGN-Nasdaq)
The company provides cooled and heated seating systems for the auto market. Americans are buying more cars "at an aggressive rate," while Amerigon is offering this product on lower-priced autos with higher sales volumes, Mr. Beckerleg said. "It is now offered on 54 models, compared with 22 in 2006. We expect that number to rise significantly over the next five years." His one-year target is more than $20 a share.
Radiant Systems Inc. (RADS-Nasdaq)
The company sells automated point-of-sale or cash machines to restaurants, and the technology is hooked into their back-office accounting systems. Radiant has an opportunity to sell other software applications, such as fraud-detection services, to the same customers and these "software add-ons are very, very high margin," he said. "We expect the software business to grow into well over $100-million over the next three years." His 12-month target is $24 a share.
O'Reilly Automotive Inc. (ORLY-Nasdaq)
This auto parts chain, whose stock has been in the GBC fund for 17 years, has been growing at a steady pace by opening new stores and through acquisitions. "As they become larger buyers of these automotive parts, they are able to get better purchasing terms from their suppliers," he said. In 2008, it acquired CSK Auto Inc., and has been able to "move its margins up nicely, and we expect it will reach O'Reilly's [margins]very shortly," he said. His one-year target is $75 a share.