The Case for Small-Caps

11/10/2014 9:00 am EST

Focus: STOCKS

James Oberweis

President, Oberweis Asset Management, Inc.

It’s been a brutal year for small-cap investors relative to those in large-caps. From the Russell peak in March, the Russell 2000 lagged the S&P 500 by a whopping 1500 basis points, observes Jim Oberweis, Jr., small-cap expert and editor of The Oberweis Report.

This isn’t the normal long-term trend. Small-caps have outperformed blue chips by an average of about 2% per year over the last 88 years, but you sure wouldn’t guess that this year: the Russell 2000 Index returned 1.7% thus far in 2014 versus a gain of 10.6% for the S&P 500.

That brings us to the tendency for what is known as mean reversion. That is, when small-caps underperform large-caps dramatically, they tend to switch direction and outperform in subsequent periods. Right about the time you start to hate them, small-caps catch fire.

There were only three times in the last decade where small-caps underperformed large-caps by a magnitude similar to the recent run of underperformance; April 2006 to January 2008, September 2008 to March 2009, and April 2011 through October 2011.

In all three cases, over the following year, small-caps fared better and outperformed large-caps by at least 400 basis points, a wide margin. In 2009, the subsequent outperformance was massive (2500 bps).

All else equal, when one asset class by market cap becomes truly unloved, the odds become much higher that it is on the verge of coming back in style.

Current valuations relative to historic averages support this view. The Oberweis Universe Median P/E (measuring valuations for high growth small-cap stocks) is currently 14% below its average over the last decade.

On the other hand, the S&P Index P/E, at 17.9, is 14% above its decade average. That is, high-growth small-caps would need to rally roughly 30% just to reach valuation parity with blue chips.

While it’s hard to time the market, it’s worth remembering that markets roll in cycles and there are times when favorable probabilities emerge. Previous periods of small-cap underperformance are often harbingers for periods of outperformance.

The case becomes even stronger when small-caps trade at comparatively better valuations than blue-chips. The tendency toward mean reversion—both for pounds and percents—shouldn’t be ignored when placing your bets.

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