Small Caps Rediscovered At 47 Times Earnings As Dollar Hits S&P
By Callie Bost and Michelle F. Davis
(Bloomberg) — A surging U.S. dollar has revived investors?
appetites for small-cap stocks, a group they just got done
punishing for excessive valuations.
The Russell 2000 Index is trading at the highest price
relative to the Standard & Poor?s 500 Index in eight months.
Hedging costs on the most popular exchange-traded fund tracking
small-cap companies have dropped to the lowest since October
relative to the biggest ETF on the broader-market gauge.
With the dollar near a 10-year high relative to its peers,
investors are looking past a price-earnings ratio of 47 and
buying small-caps instead of companies with more overseas sales,
according to JC O?Hara at FBN Securities Inc. The Russell 2000
endured some of the heaviest selling last year, dropping as much
as 13 percent after trading at more than 60 times annual
earnings.
Investors ?are willing to pay for a stock that does better
in a rising-dollar environment,? O?Hara, the New York-based
chief market technician at FBN, said by phone. ?It?s the lesser
of two evils. Just because it?s at 46 times earnings doesn?t
mean it can?t go to 50 times, but the strength of the dollar is
something a lot are watching.?
Currency Impact
The Russell index of smaller companies has jumped 2.7
percent this year to 1,236.64, while the S&P 500 has risen 0.3
percent to 2,065.95. The large-cap measure trades at 1.7 times
the Russell 2000, the lowest ratio since July.
Shares of smaller companies have outperformed the S&P 500
in 2015 as the strengthening dollar eats into earnings of the
biggest U.S. corporations. Companies from Procter & Gamble Co.
to DuPont Co. and Pfizer Inc. said last earnings season the
currency?s strength is hurting profits.
The dollar is trading around the highest level since 2005
as the Federal Reserve moves closer to an interest-rate
increase, while the European Central Bank started monetary
stimulus and the Bank of Japan has announced plans to do the
same.
Strength in the dollar reduces foreign-currency earnings
when they are repatriated back to the U.S. Russell 2000
companies get an average of 83 percent of their sales from North
America, according to data from the firms in the index that
provide the information in their financial statements. That
compares with 70 percent for S&P 500 companies.
?Dollar Problems?
?When I?ve got a choice of of where to put money in equity
markets, the small caps certainly look attractive right now
because they don?t have these dollar problems,? Randy Warren,
who manages more than $100 million at Exton, Pennsylvania-based
Warren Financial Service & Associates Inc., said by phone.
Traders? renewed interest in small companies is a reversal
from 2014. The Russell 2000 rose 3.5 percent last year after
plunging as much as 13 percent from March to October as the
gauge expanded to 61 times the earnings of its constituents. The
S&P 500 surged 11 percent in 2014, with valuations climbing as
high as 18.5 times profit.
Small-cap stocks increased more than 250 percent in the
five years following its low in March 2009 to get to those
valuations, beating the S&P 500 by more than 70 percentage
points.
Price-earnings multiples in the gauge could motivate some
investors to take profits like last year, according to Alan
Gayle at RidgeWorth Investments. The index of smaller companies
currently trades at 46.9 times earnings, more than twice the S&P
500?s valuation of 18.5 times.
Lofty Valuations
?The general investor is on the fence for small-caps,?
Gayle, senior strategist at RidgeWorth, which manages $44.5
billion in assets, said by phone. ?They want to like small-caps
because they tend to perform well over time, but valuations and
past performance are making people reticent in a market that?s
become more volatile.?
Small-cap companies? strength this year has prompted
options traders to shed hedges on the iShares Russell 2000 ETF.
Contracts on the fund March 11 cost 1.2 times as much as those
on the SPDR S&P 500 ETF Trust, the smallest ratio since October,
according to one-month data compiled by Bloomberg.
The divergence between the two funds? hedging costs has
dropped 28 percent since Nov. 21. The Russell 2000 has rallied
5.5 percent since then. The Chicago Board Options Exchange
Volatility Index of S&P 500 options costs has dropped 20 percent
this year to 15.42. The CBOE gauge of Russell 2000 options has
plunged 22 percent.
Corporate Earnings
The gap in valuations between small-cap and large-cap
stocks closes when future earnings are factored in. Analysts
expect profit for Russell 2000 companies to expand 80 percent in
the next 12 months, while S&P 500 corporations? earnings are
predicted to rise 6.9 percent in the same period, Bloomberg data
show.
Small-cap stocks trade at 26.4 times expected earnings,
while S&P 500 companies are valued at 17.4 times estimated
profit, according to Bloomberg data.
?I don?t think the valuations vis-a-vis the larger caps
are excessive given the fact they?ll weather this dollar
storm,? Randy Bateman, the chief investment officer of
Huntington Asset Advisors, said by phone. ?Obviously, the S&P
500 is a bit cheaper, but in a risk-on environment without many
alternatives out there to stocks, with small- and mid-caps you
get a higher rate of return.?