Are Small Cap Valuations Getting Extended?

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 |  Includes: DWAS, EWSC, FYX, IJR, IWM, JKJ, PXSC, RSCO, RWJ, RWM, SAA, SBB, SCHA, SDD, SLY, SMLV, SRTY, TNA, TWM, TWOK, TZA, URTY, UWM, VB, VIOO, VTWO, XSLV
by: David I. Templeton, CFA

Since the beginning of November, small cap stocks have been underperforming large caps. This recent underperformance has strategist questioning whether the small cap outperformance, since the end of the financial crisis in 2009, is coming to an end. As the below chart shows, since February 2009, small caps have significantly outperformed large capitalization equities.


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From The Blog of HORAN Capital Advisors
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This outperformance has caused the valuation of small caps to reach a premium relative to large caps. T. Rowe Price recently highlighted this valuation premium in their Fall 2013 T. Rowe Price Report newsletter. The below chart that accompanied the article, Leading Market Recovery, Small-Caps Face New Challenges, notes small caps are selling at a 14% premium to large caps.


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From The Blog of HORAN Capital Advisors
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Preston Athey, manager of T. Rowe Price's Small Cap Value Fund, states, "It’s harder finding attractive opportunities today than two to three years ago, so a value investor tends to be cautious. We’re paying 15 times earnings today for companies that were selling at 11 times earnings three years ago."

I believe investors should take to heart Athey's cautionary comment of, "But if we get a major correction or a mild recession, the market will go down and small-caps will do worse because this sector is more volatile. After a long period of good performance and outperformance, the caution light should be on now rather than flashing green."