‘Returns are best’ in neglected U.S. small caps

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This week's column featured strategist Richard Bernstein's investing maxim that "returns are best where capital is scarce" and its implications of limited investor returns in the current cash-flush environment. In an e-mail exchange with Mr. Bernstein during research for the piece, Mr. Bernstein outlined an area where he does see a scarcity of capital and the possibility of strong investor returns: non-technology U.S. small-cap stocks.

The premise of Mr. Bernstein's advice is that current market conditions – with huge and constant central bank liquidity injections – imply that any investment vehicle generating a consistent stream of revenue will quickly become overpriced. He notes that "energy and commodities are the exact opposite of where they stood a decade ago" [when the sector had to beg for investment funds] and "emerging markets have been flooded with capital beyond their productive use."

The areas where Mr. Bernstein recommends searching for value are small-cap sectors outside of technology where "U.S. companies are still having financing problems."

In an effort to narrow things down for investors we sorted all companies in the Russell 2000 small-cap index by industry, and then by price earnings ratio (see chart to left). The most attractively valued U.S. small-cap sectors according to this exercise are financials and consumer cyclicals.

This is only a starting point, but the low median price earnings levels in those sectors does suggest that stocks are currently starved for investment capital. And, following Mr. Bernstein's advice, in cases like these where capital is scarce, stronger returns should be available for investors.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.