Today begins a two-part series exploring premiums, starting with the size premium. With the dramatic outperformance of U.S. small-cap stocks over the past several years, we've had many stories in the financial media warning investors about their future performance. Since valuations are the best predictors of future returns that we have, we can examine the warnings to see if the hold up.
We'll begin by first looking at the returns of small caps relative to the total U.S. market. From January 2008 through March 2014, Dimensional Fund Advisors Small Cap Portfolio (MUTF:DFSTX) provided a total return of 87.5 percent (annualized return of 10.6 percent). Over the same period the U.S. total stock market, as represented by the Center for Research in Security Prices (Pending:CRSP) 1-10 index, returned 54.5 percent (annualized return of 7.2 percent). Thus, DFSTX outperformed by a total of 33 percent (an annualized difference of 3.4 percent). (Full disclosure: My firm Buckingham recommends Dimensional funds in constructing client portfolios.)
When looking at this differential, most investors would conclude that given the outperformance, the valuations of small-cap stocks must now be relatively much higher. However, while that is possible, it isn't necessarily the case. The reason is that typically most of the outperformance of small-cap stocks isn't due to the overall performance of the asset class. Instead, it's due to the very large outperformance of a very small number of small-cap stocks. And because of their very high returns, those stocks may have "migrated" out of the small-cap asset class and become mid-caps or even large caps. If the stocks that migrated did in fact account for much of, or even all of, the outperformance, then relative valuations might not have changed much. With that in mind we'll now look at the book-to-market ratio (BtM) of DFSTX and the CRSP 1-10 to see what changes have happened over this period.
At the end of December 2007, the BtM of DFSTX was 0.52 and the BtM of the CRSP 1-10 was 0.42, producing a ratio of 1.24 (.52 divided by .42). At the end of March 2014, the respective figures were 0.50, 0.43 and 1.16. As you can see, despite the significant outperformance by small caps, the relative BtMs have haven't changed much at all - certainly nowhere near the 33 percent difference in performance. Next we'll look at the P/E ratios.
At the end of December 2007, the P/E of DFSTX was 30.0 and the P/E of the CRSP 1-10 was 25.9, producing a ratio of 1.16 (30.0 divided by 25.9). At the end of March 2014, the respective figures were 25.0, 20.8, and 1.20. Once again, despite the significant outperformance by small caps, the relative P/Es haven't changed much at all -- certainly nowhere near the 33 percent difference in performance.
Perhaps the small cap premium has come down a bit, but at least using these valuation metrics, there's no evidence of small caps being highly overvalued.
Next, we'll ask whether or not the realized equity premium has been shrinking.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.