A recent Globe Investor newsletter noted that Goldman Sachs equity strategist David Kostin was recommending U.S. small-cap stocks as a pocket of value in a market that is very expensive by most measures. Attractive valuations in the sector led Mr. Kostin to forecast a return of 15 per cent for the small-cap Russell 2000 Index in 2024. This compares to his 8-per-cent forecast return from the large-cap sector.
While this may be an attractive proposition on the face of it, value and contrarian investment strategies are a tough sell when recent history has been painful. That is certainly the case for small cap and value in the United States, where the risk-return tradeoff has been upside down for the past decade.
For the past 10 years, the big-cap Russell 1000 Index has beaten the small-cap Russell 2000 by 4.6 percentage points a year, while for calendar 2023 alone the spread was almost 10 percentage points. Making this experience more painful, small-cap returns were more volatile so more risk failed to deliver a higher return: As measured by the standard deviation, the annual variability of small caps over the past decade was 20.2 per cent compared with 15.4 per cent for the big-cap index. Almost one-third more market price risk for significantly lower annual returns. Not what you read in the finance textbooks.
With this as background, why would anyone set foot in the small-cap value quagmire? In looking back over my 50-year career as a value-oriented portfolio manager, I recall two comparable situations. One was in the early 1970s when the Nifty Fifty “one decision” stocks favoured by the big institutions dominated the market index until they collapsed in 1974. This was followed by a decade of outperformance by small cap and value, leading to the creation of Saxon Small Cap and other similar funds.
The second situation was more recent and therefore more familiar: In the late 1990s, telecom and internet stocks soared even if they had no viable business model. Northern Telecom grew to represent 30 per cent of the TSX Composite Index market weight. This was not considered an anomaly. Active managers petitioned the regulators to relax the rule that set 10 per cent as the maximum portfolio exposure to any one issuer because they could not compete with index funds, which had a full weight in Nortel. Fortunately, the regulators of the time were either smart or comatose and they never got around to making a change. The internet stocks and Nortel promptly cratered in the spring of 2000.
Needless to say, value investors had no clue as to when or if interest would return to small-cap value, and there was a lot of talk at the time about paradigm shifts. We have passed through several paradigm shifts and the world is very different now, but one investment paradigm remains constant: It is never a good idea to pay an extravagant price for even a great stock. When price-to-sales ratios replace price-to-earnings ratios as a rationale for a purchase recommendation, it is probably time to revisit the fundamentals.
Which brings us back to the attraction of small-cap stocks in the United States. Are they inexpensive on an absolute basis, or only relative to the generous valuation criteria of the big-cap sector?
Sticking with the Russell indexes as of Dec. 31, 2023, we find that the price-to-book ratio of the big-cap 1000 index is a generous 4.26 times while the comparable price-to-book ratio for the small-cap 2000 is a more reasonable 2.11 times. If you can tolerate the risk associated with the Russell 2000 Value Index, which is both small cap and value, the price to book drops to a very attractive 1.41 times.
A similar situation prevails with the price-to-earnings ratios. The big-cap index reports a trailing ratio of 23 times, the small cap 15.8. The small-cap value comes in again much lower at 12.6 times. It is true that the five-year earnings growth rate for each sector shows a similar downward trend, but even if you divide the price to earnings by the growth rate to compute a so-called PEG ratio, small cap still comes out ahead.
You cannot buy an index, but there is no shortage of low-cost exchange-traded funds that replicate the various Russell indexes. If you have the patience and fortitude to stick with small cap and value, there is an investment vehicle waiting for you. My own preference will be the Russell 2000 Value Index benchmark.
It might be tempting to make a similar leap of faith and invest in the Canadian S&P/TSX Small Cap ETF because small caps in Canada have also lagged the overall S&P/TSX Composite by three percentage points a year for the past decade.
The strategy is more difficult to defend here because our small-cap index is dominated by materials (29 per cent) and energy (21 per cent). Price-to-book and price-earnings ratios are less meaningful in these sectors, and returns will be driven by global commodity prices rather than a narrowing of the valuation spread between large and small companies. In this case, the U.S. analysis does not translate well into Canada.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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Robert Tattersall