By the time the daily financial media issues the death sentence of a particular asset class, investment style or, in today’s case, market cap segment, chances are professional and sophisticated investors have long ago been in on the trend. From our experience, it’s also the time when some of the best investment opportunities present themselves. We’re referring in particular to the not-so-secretly telegraphed demise of the small cap segment of the U.S. stock market. Depending on whom you listen to (or read), small caps have been, all year, the most overvalued, the most unloved, the most shorted or the ripest-for-a-correction segment of the market. Without having to read anyone’s opinion, it has definitely been the part of the market that has fared the poorest. Through Wednesday’s close (as we wrote this column), the Russell 2000 was down 1.5% for the year, trailing the Dow Jones U.S. Total Stock Market Index’s gain of 5.9%, a not insignificant underperformance of 740 basis points (hedge fund managers get fired for such numbers but that’s more cocktail reception fodder than anything worth discussing here).
What does this mean for B400? Well, considering B400 is an equally weighted index and that today 35% of its constituents sport a market cap below $3 billion, it means that small caps have also been a drag on B400’s performance. Also through Wednesday, the index was up 3.4% for the year, 250 basis points behind the aforementioned total stock market index. Below, John Prestbo does a superb job of breaking down the numbers behind this small cap underperformance and the impact they’ve had on B400, so we won’t steal his thunder. Instead, we’ll focus briefly on how justified the recent selloff in B400 small caps has been since, after all, the index doesn’t own all of the Russell 2000. And given today’s tendency of market segments to move in unison, at least in the short term, it’s worthwhile reminding our readers that B400 constituents tend to be the cream of the U.S. crop regardless of size.
So, what has dragged small caps down this year? The same two things that typically drag down any given set of stocks: valuation concerns and diminished growth expectations. So let’s explore both for B400’s current crop of small companies. From a valuation perspective, B400 itself isn’t too far away from the market’s widely followed benchmarks. The index currently trades at a median forward P/E of 16.9 and a trailing P/E of 19.1. Its median forward PEG ratio, which simply means its forward P/E ratio divided by its expected EPS growth rate, is 1.13. This number is perhaps a better illustration of valuation since it takes into account a given stock’s (or in this case the median of a collection of stocks) expected growth rate. On the other hand, B400 companies are expected to grow earnings, over the next 12 months, by a solid 13% (also the median), which compares very favorably to the S&P 500’s one-year forward EPS growth of 7.6% according to FactSet. Given B400’s GARP DNA, no surprise here.
When we break these numbers down into market cap segments, things get really interesting. From a valuation perspective, B400’s small caps are not even the most expensive segment of the index. Based on a median forward P/E of 16.9, they are less expensive than the index’s large caps, which trade at a median forward P/E of 17.3. In fact, small caps’ forward P/E matches the median P/E of the entire index. Mid caps, with a forward P/E of 16.1, are squarely, err, in the middle. Based on PEG ratios small caps also appear to be cheaper than their larger brethren. The forward PEG ratio for the segment is 1.0 compared to 1.3 for large caps. Mid caps also have a PEG ratio of 1.0. A caveat, though: small caps is the segment with the largest number of companies that have a negative expected EPS growth rate over the next year, with 40, out of 141 small caps in B400, or 28% of the group, expected to earn less in the next 12 months than they did in the past 12 months. By comparison only 10% of large caps and 12% of small caps in B400 have negative expected EPS growth rates. This is pretty understandable since smaller companies typically display much higher volatility of earnings than larger, more stable companies do. They also tend to grow a heck of a lot faster.
So, what now? Well, we still have not been able to get our hands and that elusive crystal ball but from past experience, we can deduce three things: first, despite higher earnings volatility, B400 small caps are still expected to growth their earnings by a tad over 11% in the next 12 months, 46% higher than the S&P 500. Second, at current valuations small caps are not that much more expensive than large caps; in fact, by several measures, they appear to be cheaper. This is especially true since B400’s small caps have fallen in price by a median 3.5% since the index’s March rebalance while large caps have gained a median of 5.5%. Lastly, although this isn’t much of a deduction but in fact a hard truth, today’s set of small caps will not be the same set of small caps after the upcoming September rebalance. So, in conclusion, what would you rather own today, the companies that have gained or the companies that have lost the most this year considering both are likely to growth at about the same pace? B400 gives you a pretty mix of both.
| All | M.Cap | NTM P/E | EPS Gr. | NTM PEG | P/Sales | Price Chg. |
| Median | $4.6 bn | 16.9 | 13.0% | 1.13 | 2.3 | 1.7% |
| Large Caps | ||||||
| Median | $25.9 bn | 17.3 | 13.0% | 1.26 | 2.8 | 5.5% |
| Mid Caps | ||||||
| Median | $4.9 bn | 16.1 | 14.1% | 1.03 | 2.1 | 2.1% |
| Small Caps | ||||||
| Median | $1.4 bn | 16.9 | 11.1% | 1.00 | 2.1 | -3.5% |
NTM = next 12 months
EPS Gr. = expected EPS growth in next 12 months vs. last 12 months
NTM PEG = Forward P/E Ratio / Forward EPS Growth
P/Sales = based on trailing 12-month sales
Price Chg. = change in share price since March B400 rebalance
B400 Performance Is Held Back by Small Stocks
By John Prestbo – 07/31/2014
The Barron’s 400 Index this year is in the unusual position of trailing the broad market. Why is this happening to a grouping of stocks belonging to the financially strongest companies in the United States?
At the close on July 25, the Barron’s 400 had risen 4% so far this year, while the broad market had advanced 6.25%.
The performance difference is partly explained by how these two indexes are designed. The Barron’s 400 is an equally weighted index, which mean at each semiannual rebalancing every stock weighs the same, 0.25%, no matter how big or small its company is. By contrast, the DJ Total Market Index is, like almost every benchmark, weighted by market capitalization—which is how size is usually determined in the stock market. The effect is that large companies have a much greater influence on index behavior than small companies.
And since late April, Mr. Market has favored larger over smaller companies. The degree of favoritism is shown in the table below, which has three price-movement measurements of stock-size segments. The first is for the year through July 25 and is the most comprehensive. However, because the current Barron’s 400 components were selected in the spring, the second measure shows price action since the re-composition on March 21. The third measure is of price changes in July through the 25th.
| Since 12/31/13 | Since 3/21/14 | Since 6/30/14 | |
| Large(>$14 billion) | 15.34% | 10.96% | 1.85% |
| Mid(< $14 billion and > $3.9 billion) | 8.22% | 2.96% | 1.47% |
| Small (< $4 billion) | -4.12% | 5.54% | 2.26% |
The table shows that small stocks were battered early in the year. While spring and summer gains have mitigated those losses somewhat, the segment is still “under water.” For mid-caps, which are a perennial favorite of investors, half the gains came before many of the stocks were included in the Barron’s 400 Index and therefore didn’t contribute to index performance. By contrast, most of the gains for large stocks have come since the components were revised in March, which means they have driven the index’s behavior since then.
The reason for the shift in favor of large stocks was the opinion of market strategists that small and many mid-sized stocks were overpriced or fully priced after their strong run-up in 2013. Large stocks, which brought up the rear last year, were deemed undervalued and therefore lured money out of the small and mid-sized segments.
It may seem strange that an equally weighted index such as the Barron’s 400 would be affected by differing price action according to stock size. But the market’s key trends are reflected in all indexes no matter how they are weighted. Since the equally weighted index enlarges the weights of small and many mid-sized stocks at the expense of large stocks, a slowdown or decline among the smaller components will weigh heavier on an equally weighted index’s performance than a pickup in large stocks.
This is particularly true of the Barron’s 400, where small stocks constitute nearly 44% of the index. The table below shows the size-segment weighting details by sectors:
| Large Cap | Mid Cap | Small Cap | |
| Consumer Discretionary | 24.05% | 32.91% | 43.04% |
| Consumer Staples | 37.50% | 25.00% | 37.50% |
| Energy | 23.53% | 29.41% | 47.06% |
| Financials | 20.90% | 31.34% | 47.76% |
| Health Care | 36.67% | 30.00% | 33.33% |
| industrials | 18.42% | 35.53% | 46.05% |
| Materials | 14.81% | 44.44% | 40.74% |
| Technology | 31.15% | 24.59% | 45.16% |
| Total Index | 25.56% | 30.72% | 43.72% |
Small stocks dominate five of the sectors, and only consumer staples and health care have small-stock weights below 40%. Health care is the only sector in which large stocks—the big pharmaceutical makers—prevail. These differences matter because price-action varies by sector as well as stock size. The result is extra price oomph in some parts of the index and additional price drag in others, as the following table shows.
| Since 12/31/13 | Since 3/21/14 | Since 6/30/14 | |
| Consumer Discretionary | 0.57% | -2.14% | 0.14% |
| Consumer Staples | 1.84% | 1.34% | -1.85% |
| Energy | 15.57% | 12.06% | -1.70% |
| Financials | 1.71% | 1.56% | -1.28% |
| Health Care | 18.40% | 6.58% | 4.36% |
| industrials | 5.42% | 2.23% | -0.34% |
| Materials | 7.99% | 1.25% | -0.58% |
| Technology | 23.14% | 17.15% | 0.08% |
Technology and energy have contributed the most since the Barron’s 400 was reconstituted in March. Health care, which started out strong, has weakened in its contribution since spring, though it had the best performance in July. The sector with the worst performance overall is consumer discretionary, reflecting the continued hold on spending that consumers have been exhibiting all year. Consumer staples also are showing weak performance, though it is positive since spring. Financials, one of the larger sectors but with a 47% weighting in small stocks, have been lackluster.
Though the market’s winds and currents haven’t been favorable to the Barron’s 400 this year, the only safe prediction to make is that this, too, will change. We just don’t know when, exactly, or how. At that point, and even until then, investors in stocks of financially strong companies will be in the best position to profit from wherever Mr. Market goes next.
