By Stan Choe
Small stocks have brought big joy this year, but they’ve been so generous that some mutual fund managers question how much they have left to give.
Stocks of smaller companies have surged even more than the broader market, which itself is closing in on its best year in a decade. The average small-cap growth mutual fund is up 35 percent this year, compared with 29 percent for large-cap growth funds, according to Morningstar. The big jump in prices for small company stocks means investors are paying more per share for each $1 in earnings produced by the companies, an indication that the stocks are more expensive.
“The valuations of small-cap stocks as a group are honestly ridiculous right now,” says Adam Strauss, portfolio manager at the Appleseed fund (APPLX).
His fund can buy stocks of any size, and in late 2011, it had a $2.7 million investment in Albany Molecular Research, which helps biotechnology and pharmaceutical companies develop and make drugs. The stock surged 80 percent last year. It followed up by doubling within the first four months of this year, though it has been declining since hitting a five-year high last month.
The Appleseed fund sold all its Albany Molecular Research early this year. Its managers told investors after the sale that it tries not to fall in love with stocks, particularly after the good things they expected did actually happen.
“I’m not going to say there’s a lot of value available in the market, because there’s not,” Strauss says. “But to the extent that there is value, there’s more value in large companies than smaller companies in this market.”
To be sure, some money managers have been saying for years that small-cap stocks look expensive, only to watch them continue to rise.
Small-cap stocks generally have market values of less than $5 billion (for comparison, Apple is worth about $512 billion), and they include everything from small oil producers to household brand names. La-Z-Boy, Nutrisystem and restaurant chain Buffalo Wild Wings are all small-cap stocks, and each has doubled this year.
The Standard & Poor’s 600 index of small-cap stocks trades at 21 times its earnings per share over the last 12 months. Over the last 10 years, the index has had an average price-earnings ratio of 17.
What’s more, small-cap stocks are at extreme valuations when compared against large stocks, says Doug Ramsey, one of the managers atop the Leuthold Core Investment fund (LCORX) and the Leuthold Global fund (GLBLX).
He believes looking at stock prices relative to their earnings per share over the last five years has been a better predictor of future performance than looking at earnings over just the last 12 months. By that measure, he says small-cap stocks recently were 38 percent more expensive than large-cap stocks. That’s the largest difference he has on record, stretching back to 1986.
During the late ’90s and early in the last decade, small-cap stocks were cheaper than large-cap stocks, based on the measure.
“We’re coming up on five years of this bull market, and I don’t think it’s the time to be going into the most expensive area of the U.S. market,” Ramsey says.
But Ramsey acknowledges that small-cap stocks could keep rising in the short term: Price-earnings ratios are a better guide for where markets are heading in the long term. Ramsey recently made a small investment on the expectation that small-cap stock prices would fall, but he got out of it after they kept rising.
Fund managers who specialize in small-cap stocks also point to several advantages that smaller companies have over big multinationals. The global economic recovery is weak, with Europe’s unemployment rate close to a record high and emerging markets struggling to cope with slower growth.
“If you look at large-cap, mega-cap companies, they are heavily tied to global GDP,” says Robert Lanphier, portfolio manager at William Blair’s Small-Mid Cap Growth fund (WSMNX), which has a four-star rating from Morningstar. “Small and mid-sized companies are much more agile and have much more flexibility in how they approach growth.”
Also, if the tepid global economy pushes big companies to start making acquisitions to drive growth — and they have a record amount of cash with which to do so — small-cap stocks will often be the beneficiaries, Lanphier says.
All this is coming amid worries that higher price-earnings ratios across the market will mean a slower climb for stocks. For example, T. Rowe Price’s forecast for 2014 returns is more cautious than for the last two years, when it offered a green light to go into stocks. This year, it’s yellow.
For small-cap stocks in particular, “I’d say it’s a flashing red light, but not a full red light,” says John Linehan, head of the U.S. equity division for T. Rowe Price.