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Talking Points: August/September 2011

What Morningstar analysts are hearing about small caps' continuing popularity. 

Morningstar Analysts, 08/15/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription here. 

What Morningstar analysts are hearing about small caps' continuing popularity. 

The Issues
Morningstar analysts compared small- and large-cap stock valuations in November and found that, after a decade of strong performance, small companies looked pricey relative to big ones. More than seven months later, the relationship hasn't changed. Small caps still look expensive relative to large caps and are still getting more investor attention. Since November, investors have added $11 billion to U.S. small-cap stock funds through May, while large-cap funds have had $20 billion in outflows.

Small caps don't offer the same opportunity they did a decade ago. The small-cap Russell 2000 Index's forward price/earnings ratio is at a 24% premium to the large-cap Russell 1000 Index's, according to Morningstar data. In June 2001, the Russell 2000 Index traded at a 29% discount to the Russell 1000 Index.

Some small-cap portfolio managers, though, believe there are still attractive opportunities among higher-quality companies within the small-cap universe. Still, investors expecting a repeat of the past decade might be disappointed. Small caps can still diversify a portfolio, so it may not be prudent to completely bail on them, but adjusting expectations and rebalancing would be wise.  

The Points
* Relative valuation matters. In early 1993, the Russell 2000 Index traded at a nearly 10% premium relative to the Russell 1000 Index, but by early 2000, the small-cap index was at a 40% discount to the large-cap one. During that time period, the Russell 2000 Index gained 14% annualized, which was a nice absolute gain but 7 percentage points less than the Russell 1000 Index's advance. Then small caps took the lead from 2000 through June 2011 and moved back to a premium. There's no telling when large caps and small caps will switch places again, but history shows they are likely to. At the very least, small caps lack the cheap valuation tailwind they had in 2000.

* From the start of 2010 through now, 22 small-cap funds have closed their doors to new investors. Several top-performing small-cap managers also have launched multi-cap funds, in part to take advantage of opportunities among larger stocks. Charlie Dreifus of Royce Special Equity RSEFX launched Royce Special Equity Multi-Cap RSEMX at the beginning of this year. Glenn Gawronski of JPMorgan Small Cap Equity VSEAX launched JPMorgan Mid Cap Core JMRAX at the end of 2010.

* Small caps have historically sold at a premium to large caps, but today's prices are particularly high. The Leuthold Group states that small caps have sold at a roughly 1% median premium to large caps since 1982. According to Steven Romick of FPA Crescent FPACX, that can be attributed to small-cap stocks having less coverage on Wall Street than do large caps, having less complexity, and having a greater likelihood of being acquired.  

"Prices in the small-cap market have continued to increase in 2011, making buying highquality businesses at a discount even more challenging. Although the operating environment for many of our businesses has improved considerably during the past two years, much of that improvement has been reflected in the price of their stock. As has been the case in past small-cap cycles when valuations appeared elevated, we believe patience and flexibility are required."
Eric Cinnamond
Aston/River Road Independent Value ARIVX 

"Small caps look expensive in the U.S. and in Europe and in Japan and in emerging markets. As you get bigger and bigger over to the mega-caps, the mega-caps look cheap everywhere, and that's weird. It doesn't happen very often, but right now they look like the best risk/reward play out there."
Ben Inker
Wells Fargo Advantage Asset Allocation EAAFX  

"The Federal Reserve tracks a large number of indicators. Overall, these indicators do not obviously point to significant excesses or imbalances in the United States. For example, forward price/earnings ratios in the stock market fall within the ranges prevailing in recent decades and are well below the early-2000 peak, although corresponding measures for small-cap equities appear somewhat elevated."
Janet Yellen
Board of Governors of the Federal Reserve System

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