Small-Caps Cheaper Than The Market

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In their recent episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discuss Small-Caps Cheaper Than The Market. Here’s an excerpt from the episode:

Tobias: So, cool. Let me kick it off. A few things that I wanted to note. So, we’ve blown through 40 on the Shiller PE, Fear & Greed’s at 86 which is pretty greedy.

Jake: Is that good or bad?

Tobias: It’s greedy. Not if it’s good or bad. People are feeling pretty good at the moment. Last time, we went through 40, it was January 1999. So, you’ve got a solid 12 months before you hit 44 on the Shiller PE and China and Japan get to 100 times. So, don’t panic yet. The forward returns over a decade assuming mean reversion from hereabout–

Jake: Are strong to quite strong? [laughs]

Tobias: Negative 0.1% on the index but 1.2% total return which includes 1.3% in dividends. So, we’re all going to be dividend clippers for the next decade. The MarketWatch article was called– I tweeted it out, but a bargain you can’t ignore. Small cap stocks are trading at the second biggest discount in 20 years, and the biggest discount was last year in March 2020. There’s just a few interesting things out of this. So, they went through the forward P/Es. So, the current forward P/E for S&P small cap 600 is 15.6, and the S&P 500 is at 21.59. So, they’re saying that there’s like a 72%– The S&P 600 is 72% the valuation of the S&P 500.

Now, you might say, “So what? Small caps should trade at a discount to the rest of the market.” But I thought this is kind of interesting. So, the three-year average, small is 16.7, large is 19.5. So, the valuation over the last three years, the disparity hasn’t been as wide. The five-year average is 16.6 versus 18.7, closer still. 10-year average 15.8 versus 16.2, closer still. 15-year average, 15.3 versus 15.5, roughly identical. Then, the 20-year average is 15.3, 15.7. So, again almost identical. Smalls haven’t traditionally traded at this bigger discount. So, it’s entirely possible that–

Jake: If you could summarize that, then it might be saying that historically, they roughly trade comparably on forward P/E, but as the last 20 years have unfolded, the bigger, the more expensive it’s gotten.

Tobias: Unfortunately, that’s the takeaway from that. The smalls are roughly trading where they have for the last 20 years. It’s the S&P 500 that has exploded, has become much more expensive over that period of time. You could make an argument there’s the composition of the index, but this is a kind of interesting thing. So, you’re looking at growth rates for S&P for the smalls versus the 500. So, they’re predicting sales growth is going to be faster for the smalls at 7.8% versus 6.7% earnings per share.

Smalls, 14.1%, large 8.2, which is still pretty good increase year-on-year. And free cash flow per share for the smalls growing 20.7 and large 14%. So, on every metric, smalls are growing faster and they’re cheaper which makes me like smalls more than the rest of the index. That part that I was talking about earlier with the index on a cyclical basis being so expensive, I think it’s tough to be in the index at the moment. I think you probably want to be somewhere else.

Jake: Well, is that the market sniffing out returns to scale?

Tobias: Yeah. Possibly.

Jake: Bill?

Bill: I would be inclined to say yes, and I’d also like some index construction. So, yeah.

Tobias: Smalls are shittier. There’s no question but they are growing faster.

Bill: Yeah, but I don’t know. I guess I’m not sure what the growth means. But I don’t know. These are tough things without the components of the index for me. For instance, Microsoft is going to have a large percentage of the S&P weighting, right? Just by definition how big it is. Their returns on capital are quite a bit better than most smalls, and they’re growing at quite a bit higher rate, and I would argue they’re actually critical infrastructure to the way the world works. So, they’re not going to trade where smalls trade.

Tobias: That’s true.

Bill: You take Microsoft out of the world, the world doesn’t function. So, I think– [crosstalk]

Jake: Let me try to push back on that just for fun.

Bill: Okay.

Jake: Not necessarily whether I agree with this or not, but could you have made the case back in, let’s say, 2004, 2005, 2006, 2007, whenever, that a company like Exxon, which was a huge part of the market cap of the index at that point and had monster scale, and was obviously important to making the economy work, we need oil to run this whole thing, why would that be any different? Now, it’s gets kicked out, and it’s effectively stock non-grata, and the world definitely changes, over time.

Tobias: That was a quick fall for that stock, wasn’t it? Not quick in decades, but amazing that it was. At one stage, it was like 40% of the index. It’s nuts. It’s huge.

Bill: Well, I mean, so even index– [crosstalk]

Jake: Critical infrastructure, Toby.

Tobias: Yeah, arguably. You need energy to make stuff go. I understand that’s how it works. I’m not an engineer.

Bill: Okay. The highest return on assets that Exxon ever achieved appears to be-

Tobias: Yeah. It’s not as good, no question.

Bill: -18.4%, and they sell their goods through undifferentiated gas stations that anyone can go fill up their car with absolutely zero switching costs. So, you could have made the argument, but I would argue they’re quite different.

Jake: Mm, fair point.

Tobias: That is a fair point, but people didn’t seem to know. It’s sort of become a more recent thing. I do think that the S&P 500 looks like a reasonably good portfolio. If you look at the top names in the portfolio, they’re all Google, Amazon, Microsoft.

Jake: Tesla.

Tobias: Tesla, it must be.

Bill: Oh, yeah.

Tobias: I forget the top names.

Jake: [laughs]

Tobias: Yeah. [laughs] Tough to say it sometimes.

Jake: It wouldn’t cross his lips.


Tobias: It’s up there anyway. Anyway, that’s my argument. Smalls are cheap relative to the index. The index is very expensive. Probably going to be normal returns for smalls, and I think the index is going to get flattish.

Jake: I’ve heard the argument that the 99 call it value heyday renaissance. Might have been just as much a small renaissance over large as value versus growth. I don’t know exactly if that’s true or not. Toby, probably, you have a better handle on that.

Tobias: Yeah. That’s not something I’ve ever looked at particularly because I don’t have any strong love for smalls. I do think that the size effect is a little bit mythical rather than real. I’m more interested in value than I am in size. I think that the size is like a derivative of value. If two things are running $100 million a year and one’s trading at $2 billion, and one’s trading at $20 billion, the smaller one is better value. But it’s not better value because it’s small, it’s better value because it’s better value. Assuming– [crosstalk]

Bill: Microsoft return on assets isn’t great, by the way. I’m looking right here. So, I potentially am wrong, but 19% this year, 15% last year, 6% 2018 couldn’t get into how return on assets is calculated. But maybe Exxon was as good of a business. I think the switching costs was a lot lower.

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