Small Caps: Still Undervalued

Written by: Global Thought Leadership
10 January, 2020

Chart courtesy of Royce Investment Partners. Source: FactSet, as of 11/30/19. RMicro = Russell Microcap Index; R1K = Russell 1000 Index. *Enterprise Value/Earnings Before Interest and Taxes. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Chart

The chart compares, on a monthly basis from 12/31/ 2001 through 11/31/2019, the last twelve months enterprise value (EV) divided by earnings before interest and taxes (EBIT) of the Russell Microcap Index with the Russell 1000 Index.

The Bottom Line

  • Large-cap stocks have enjoyed a wide performance advantage over the past five years relative to micro-caps—the smallest investable companies.1
  • That's led to a valuation gap between them that's the biggest in nearly 20 years—based on median EV/EBIT, excluding non-earning companies, the preferred valuation measure of Royce Investment Partners.
  • As of the end of November 2019, that EV/EBIT was 17.5x for the Russell Microcap Index compared with 20.0x for the Russell 1000 Index.
  • That’s a ratio of 87%, far below the 111% average since 2001 -- as shown in the chart above.2
  • Strong performance late in the year for micro-caps3 made only a small dent in the magnitude of that discount—as illustrated by the minor upswing at the lower right of in the chart.
  • While absolute returns for both micro- and small-cap stocks were solid in 20194, Royce believes that 2020 could be another promising year both in absolute terms and relative to large caps—based on the current environment of attractive valuations, low inflation, moderate growth, and abundant capital.
  • As Royce notes, it’s not uncommon for small-caps to advance by double digits for two consecutive years—pointing out that this occurred in 1988-89, 1991-92, 1995-6, 2003-04, 2009-10, 2012-13, and 2016-17.

 


Footnotes:

1 Source: Bloomberg. For the 5-year period ending 12/31/2019, the Russell Microcap Index generated an annualized total return of 6.58% compared with 11.47% for the Russell 1000 Index.

2 Source: FactSet, as of 11/30/19.

3 Source: Bloomberg. For the 4Q19, the Russell Microcap Index generated a cumulative total return of 13.43% compared with 9.03% for the Russell 1000 Index.

4 Source: Bloomberg. For calendar year 2019, the Russell Microcap Index generated a total return of 22.43% and the Russsell 2000 generated a total return of 25.49%

Definitions:

EV / EBITDA equals a company's enterprise value divided by earnings before interest, tax, depreciation, and amortization. It measures the price (in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBITDA).

Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.

The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000 Index, plus the next smallest eligible securities by market cap.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

  • Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

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