A trio of articles covers high year-to-date returns, valuations and, consequently, increased risk of small-cap equities, especially those with growth characteristics and in the technology sector.

An article in Bloomberg indicates that the rise of small-cap stocks has historically signaled an economic improvement:

Shares of companies … in the Russell 2000 Index (RTY) have advanced 32 percent in 2013, compared with 19 percent for the Dow Jones Industrial Average. The spread is the widest for any year since 2003, according to data compiled by Bloomberg. Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.

While small-cap earnings are growing fast, valuation of these stocks has also increased:

Russell 2000 companies are beating analyst earnings estimates by 11 percent, more than twice the rate for companies in the Dow, according to data compiled by Bloomberg.

The Russell 2000’s price-earnings ratio increased 52 percent this year to 27.5 times estimated operating earnings, compared with 14.7 for the Dow, according to data compiled by Bloomberg.

The first article of the two from The Wall Street Journal brings up an issue of high stakes in the technology sector in many small-cap growth mutual funds:

Fund Ticker Technology
Conestoga Small Cap CCASX 41.5%
Brown Capital Management Small Company BCSIX 66.8%
Wasatch Small Cap Growth WAAEX 27.4%
Artisan Small Cap ARTSX 41.2%
Buffalo Small Cap BUFSX 34.1%
Loomis Sayles Small Cap Growth LCGRX 29.0%
Category Average 23.6%

The second article in The Wall Street Journal worries about small-cap returns:

Small-capitalization growth funds are up an average of 33.1% in 2013 through October, according to Morningstar Inc. That compares with average gains of 28.7% for small-cap value funds and 26.3% for large-cap growth funds. Within the small-cap growth category, many funds have gains approaching, or even topping, 40%.

However, the article states several factors propelling small-cap stocks:

  • A more direct exposure to the U.S. economy compared to large-cap stocks (per the Bloomberg article, 84% of an average Russell 2000 company sales vs. only 55% of an average DJIA company are domestic)
  • A higher rate of organic earnings growth thanks to profit reinvestment
  • A continuing low interest rate policy of the Federal Reserve that encourages investors to seek higher returns in riskier assets.

So, have investors been compensated for the increased risk of small-cap stocks? One way to determine that is to compare historical Sharpe Ratios of small-cap ETFs to those of the S&P 500® ETF (all figures to October 31, 2013 from Morningstar):

ETF Ticker 3-Year SR 5-Year SR 10-Year SR
iShares S&P Small-Cap 600 Growth IJT 1.31 0.97 0.56
iShares Core S&P Small-Cap IJR 1.24 0.89 0.54
iShares S&P Small-Cap 600 Value IJS 1.16 0.81 0.50
iShares Core S&P 500 IVV 1.29 0.94 0.45

The above data show that small-cap growth stocks have indeed provided higher risk-adjusted returns than large-cap equities did. However, the same cannot be said about the broader small-cap sector or its value component in the last three- and five-year periods.

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