Why You Should Be Wary of Small-Cap Stocks

Stocks of small companies have defied gravity for years now. From the bottom of the bear market on March 9, 2009, through February 14, the Russell 2000 index of small-capitalization stocks has returned an annualized 29.5%, trouncing the large-company-oriented Standard & Poor’s 500-stock index by an average of 4.4 percentage points per year.

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What’s more, the Russell 2000 has beaten the S&P 500 every year since 1999, except for 2005, 2007 and 2011. Over that stretch it has returned an annualized 8.2%, compared with 4.7% for the S&P. That’s the longest run of market-beating returns for small caps ever—far eclipsing the old record set from 1973 to 1983.

But that huge outperformance has made small caps “extremely overvalued” in the view of Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch. “This is the upper bound of absolute valuation,” he says.(Biotech looks even more problematic; more on that in a minute.)

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Small caps are about as expensive as they’ve ever been. Their price-earnings ratio—based on operating earnings over the past 12 months—is 23% greater than the P/E of the 300 largest U.S. companies, reports the Leuthold Group, a Minneapolis-based investment research firm. That premium is the second-highest since Leuthold began tracking the measure in 1983. (It was slightly higher in 2011).

Just look at the numbers. The 300 largest companies trade at a bit less than 16 times estimated 2014 earnings. In contrast, small caps--which Leuthold defines as stocks with a market value (share price times number of shares outstanding) of less than $3.3 billion-- trade at an average price-earnings ratio of just under 20.

What could spark a selloff? DeSanctis voices several concerns aside from valuation. First, the small-cap earnings reports in the fourth quarter were “sloppy,” he says. Year-over-year earnings growth has been a robust 12%, but more companies than usual have reported earnings below analysts’ estimates.

Second, he thinks the Federal Reserve’s tapering of its bond purchases will lead to greater volatility in the stock market. “The pickup in volatility is bad for small caps,” he says.

Third, DeSanctis says, analysts are wildly over-optimistic about earnings for the coming 12 months. On average, analysts predict that small-cap earnings will rise 20%, he says, but those forecasts are “very unrealistic.” He estimates 12% earnings growth. When companies report disappointing earnings, the market almost always punishes their stocks.

Fourth, bargains in small-cap land are scant, DeSanctis says. “Every stone has been overturned.” Only 10% of the stocks in the Russell 2000 sell for less than 10 times estimated earnings.

Companies in the Russell without earnings—which represented 12% of the index’s market value—led the index last year, an event DeSanctis calls “awfully strange.” Anytime speculative stocks lead the market, you should be concerned. Just a bit more than one-third of the firms with no profits were in health care, mainly biotechnology.

Small-cap biotech stocks have soared 72% from the start of 2013 through February 17. Many, if not most, of these companies expect to remain unprofitable for years to come, are looking for more financing and have just one or two compounds in the early stages of testing. Most such compounds never even get close to being approved for sale. and if they do get regulatory approval, the process can take years.

These biotech stocks trade at an average of 27 times revenues—that’s revenues, not earnings. That’s about 50% more than average. The only time they were more richly priced was just before the popping of the tech bubble in 2000.

The biotech industry may be approaching a turning point in drug development, and biotech companies are targeting major diseases, including cancer, dementia and heart disease. But as we learned during the tech meltdown, even if you invest in a company that is changing the world, you stand a good chance of losing money if you pay an insanely high price for its stock.

Steve Goldberg is an investment adviser in the Washington, D.C., area.