Small Caps Are Killing It

Late last week a Tweet caught my eye from Institutional Risk Analytics co-founder Christopher Whalen. It read: "Hye Kosover: 'The Russell 2000 is within 2.5% of the highest level it has 'ever' been.'"

Very simple, no associated link, but it hit on one of my favorite topics over the past year -- the outperformance of small-caps over the past decade.

Of course first, I'll go ahead and confirm that factually the Tweet is dead on. On July 13, 2007, the Russell 2000 closed at 855.77. On Friday, the index hit an intraday high of 838, which is just 2.1% below that 2007 peak.

The strength of small- and mid-cap stocks over the past decade has meant that investors that have eschewed the largest stocks in the market have done quite well. In fact, it may surprise some investors to hear that while the S&P 500 is roughly break-even today with where it was in January 2000, the Russell 2000 is up nearly 70%.

As I always have an eye on valuations, when I see that kind of outperformance, I think that there must've been some serious impact on relative valuations. And there certainly has been. To get a view of this, I looked at the average and median price-to-earnings multiples of the Russell 2000 and the S&P 500 -- which I split into quartiles based on size.

 

S&P 500 Quartile 1 (Largest)

S&P 500 Quartile 2

S&P 500 Quartile 3

S&P 500 Quartile 4 (Smallest)

Russell 2000

Mean P/E 18.5 24.5 25.7 22.8 25.9
Median P/E 16.7 19.7 20.2 18.1 19.8

Source: Capital IQ, a Standard & Poor's company.

Has this changed over time? You bet. Here's what we get if we look back 10 years.

 

S&P 500 Quartile 1 (Largest)

S&P 500 Quartile 2

S&P 500 Quartile 3

S&P 500 Quartile 4 (Smallest)

Russell 2000

Mean P/E 31.4 26.7 24.9 21.9 18.2
Median P/E 26.2 22.2 18.9 17.5 13.5

Source: Capital IQ, a Standard & Poor's company.

Indexes are current-day index holdings in 2000, not the index holdings as of 2000.

That's a pretty huge difference. And I believe it's a trend that's going to reverse itself and bring relative outperformance to larger stocks once the small caps have exhausted themselves.

When will this happen? That's a great question. Timing anything in the stock market is typically about as fruitless as trying to figure out why Kool-Aid Man doesn't break when he smashes through walls.

However, we can use valuations as a guide. Ten years ago, if you were looking for relatively low valuations, your search would have led you to smaller stocks, and you would have enjoyed a decade of outperforming the broad market. Right now, larger stocks carry the more attractive valuations -- CVS (NYSE: CVS  ) has a P/E of just over 13 and Ford (NYSE: F  ) changes hands at less than nine times its earnings -- and I think will enjoy better returns when the trend reverses.

Ford Motor is a Motley Fool Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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