By Carla Fried
The standard mantra about stocks right now is that they are no longer cheap, but merely fairly valued. While that applies to large cap stocks, small caps have shot way, way past many estimates of fair value, as earnings can’t keep pace with a massive price jump. The small cap Russell 2000 index has left the big-cap indexes in the dust over the past year:
^IUX data by YCharts
YCharts recently presented the Leuthold Group’s warning on small caps. Now the investment pooh-bahs at Bank of America Merrill Lynch (BAC) have joined the time-to-take-some-profits-on-small-caps bandwagon. In its 2014 outlook, BAML’s Research Investment Committee called out small caps as overdone. A 19.2 forward PE ratio for the Russell 2000 is nearly 30% above its historic norm. (The S&P 500 trades slightly below its historic norm.)
Small Cap strategist Steven DeSanctis added another layer of warning. He slices the Russell 2000 and the large cap Russell 1000 on four metrics: price-to-book ratio, price-to-sales ratio, trailing PE ratio and forward PE ratio. Then he sorts them by quintiles. Right now, small caps are in quintile 5, the most expensive quintile. When that has been the case in the past, small caps have underperformed large caps by an average of 5.1% and large caps outperformed small caps in nearly 90% of the periods.
If you’ve got some sluggish commodity stocks in your portfolio you can use to offset gains in small caps, now seems an especially smart time to consider a few tax-wise moves.
If you’re still looking for exposure to the small cap tilt, the portfolio of the Royce Total Return is a place to look for stocks worth further financial research. This mutual fund, co-managed by small cap legend Chuck Royce is focused on a low volatility approach to small caps, achieved in part by requiring a dividend payout. According to Morningstar, Royce Total Return has a forward PE ratio below 15, its price-to-book ratio of 1.8 is below the 2.0x for the Russell 2000, and its price-to-sales is in line with the index.
In the third quarter, among the mutual fund’s largest positions Thor Industries (THO) and Buckle (BKE) were added to. The fund also established new positions in Coronation Fund Managers (CML), Schweitzer-Mauduit International (SWM), Stein Mart (SMRT) and Worthington (WOR) Industries.