Investors may be undervaluing an entire segment of the stock market, which could lead to a decade of outperformance.
The S&P 500 is hitting new all-time highs one after another in 2024, but not all stocks are participating in the current bull market.
Big tech stocks have been driving the stock market’s valuation growth for the past few years, a trend that has accelerated recently as artificial intelligence (AI) innovations from big companies have further boosted their stock prices.
The market expects these innovators to achieve significant revenue growth over the next few years, which has led investors to raise their valuations.
But one indicator suggests the dominance of Big Tech companies is shifting, and investors could find great opportunities in a very different group of stocks.
Image source: Getty Images.
A large valuation gap that cannot be ignored
One of the most commonly used valuation metrics in investing is the price-to-earnings ratio (P/E), which tells you how much you are willing to pay for every dollar of earnings a particular stock makes. For example, if a company has generated $1 in earnings per share over the past year and its stock price is $20, then its P/E ratio is 20.
Since stocks are valued based on future expectations, looking at the forward P/E is a better indicator of whether a stock is fairly priced. Forward P/E calculates the ratio using management’s or analysts’ expectations of earnings over the next year, rather than past earnings.
Looking at stocks as a group and comparing their valuations to historical averages can help determine whether the market as a whole is overvalued or undervalued, while comparing the P/E of one segment of the market to another can help identify investment opportunities.
Currently, the difference in forward P/E ratios between the large-cap S&P 500 index and the small-cap S&P 600 index is nearly the largest it’s been since the beginning of the century. As of this writing, the forward P/E ratio for the S&P 500 is 21.3, compared with just 13.9 for the S&P 600. The last time the difference was more than 7 was just before the dot-com crash of 2001, according to Yardeni Research.
I’m not saying we’re heading towards another recession or a major market downturn in the near future, but it seems increasingly likely that the next market upswing will be driven by smaller businesses.
In the early 2000s, small-cap stocks soared while the S&P 500 struggled to rise, and history may be repeating itself.
Significant outperformance of small caps
Over the very long term, small caps have historically outperformed larger caps, but that outperformance is cyclical: small caps tend to underperform in some periods and then outperform significantly in other periods.
The last time the valuation gap between large and small cap stocks was this wide, the S&P 600 went on to deliver huge gains to investors relative to large caps.
From the beginning of 2001 through 2005, the S&P 600 achieved a total return of 66.7%, or a compound annual growth rate of 10.8%, compared to a total return of just 2.8% for the S&P 500 over the same five-year period.
Throughout 2010, including the Great Recession, small caps continued to outperform: the S&P 600 generated a total return of 109.2%, compared to the S&P 500’s 15.1%.
Data by YCharts.
How to invest in today’s market
There are a few reasons why small-cap stocks have lagged their larger counterparts in recent years. For one, rising interest rates in recent years have put pressure on small-cap stocks that rely heavily on debt for growth.
Moreover, if Treasuries offer a 5% risk-free return, investors will discount future earnings even more. That’s a double whammy for small-cap stocks. On top of that, recession fears over the past few years have led more investors to favor larger, more stable companies.
But small businesses may get some relief from high interest rates. The Federal Open Market Committee is expected to cut interest rates at least once this year. Months of better-than-expected inflation data have led markets to speculate that the Fed may cut rates more sharply. Recession fears have also eased over the past year.
If so, now could be a great time to invest in small cap stocks. You can find the best investment opportunities among small cap stocks by researching individual companies. These companies aren’t as widely followed and have fewer analysts and institutional investors buying and selling their shares, which means they have a great opportunity to outperform the overall market.
But the easiest way to buy small-cap stocks is through an index fund, like the SPDR Portfolio S&P 600 Small-Cap ETF (SPSM 0.98%) , which has the impressive ability to closely track a benchmark index with an expense ratio of just 0.03%.
Another option is an index fund that tracks the Russell 2000, a popular benchmark for small-cap stocks. It doesn’t have the profitability requirements of the S&P 600, so it includes a lot of growth stocks that aren’t profitable yet.
The S&P 600 has historically outperformed the Russell 2000, but some ultra-rich people are buying Russell 2000 index funds such as the iShares Russell 2000 ETF (IWM 1.17%) .
My personal favorite way to invest in small caps is the Avantis US Small Cap Value ETF (AVUV 0.65%). While it’s technically an active fund, it uses several profitability and valuation metrics to target small cap stocks and allocates to 774 stocks. The result is a mostly passive portfolio that still charges a mere 0.25% in fees.
While there is still room for large-cap stocks in any portfolio, investors may want to consider using one of the ETFs mentioned above to tilt the weighting toward small-cap stocks in today’s market.
