It’s easy to love small-cap stocks. These companies, which generally have a market cap of between $500 million and $2 billion, are involved in exciting businesses and if one strikes gold (literally in the case of Canada’s resource-heavy small-cap market), share prices will see a greater gain relative to their value than many successful large-cap operations.
Since 1999 the asset class has performed remarkably well. In all but two of the last 11 years, small-caps have experienced above average returns relative to other asset classes. (Look at the nifty chart below from Franklin Templeton on asset class performance over the last couple decades.) In the last two years, Canadian small-caps outperformed every other asset class with returns of 75.1% and 38.5% in 2009 and 2010 respectively.
With a decade of solid returns, it only makes sense to buy into the small-cap market, right? Not so fast, says Murray Belzberg, president of Toronto’s Perennial Asset Management. His argument is, basically, what goes up must come down.
“Trends swing a lot over time,” he says. “At times small caps have traded at a discount of almost 50% of large cap. Things have a tendency to revert to the mean.”
According to Belzberg, who gets his analysis from Ned Davis Research Inc., since 1999 small-caps have gone from undervalued to overvalued versus large-caps. Small-cap stocks are trading around 32 times price-to-earnings, while large caps are trading at about 16 times. “Small-caps are much more expensive,” he says.
So far, 2011 hasn’t been kind to small-caps—it’s year-to-date performance is -5.67% compared to -1.39% for the S&P/TSX Composite Index. If you believe that we’ll see a market pullback like Belzberg does, these stocks will fall further. Belzberg says now’s the time to reduce your small-cap concentration. “If you want to take risk out of your portfolio and still retain some upside, people should start to reduce their small-cap allocation,” he explains.
Because small-caps are riskier than large companies, share prices usually fall hard during a downturn. Just look at 2008—the asset class had -46.6% returns, the second worst according to the Franklin Templeton chart. Belzberg points out that high valuations often mean high expectations, “the slightest disappointment leaves a lot of room for downside,” he says. Expectations aren’t nearly as high for something trading at 16-times earnings.
Another reason to tread carefully around small-caps? Many investors think finding cheap, undervalued companies is the only way to buy stocks. And it’s hard to find bargains in an overvalued market. “If I can get $10 for $5, that’s a good idea,” says Belzberg.
As a general rule, think twice about buying sectors that outperform all other asset classes and look to industries that have room to grow. “Trends have a way reverting, so raise the bar in quality and look for things that you can buy at cheaper prices,” says Belzberg.