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For the first time since 2006, the "January Effect" is working, with the Russell 2000 up 5.93% in the first three weeks of the year compared to a 4.7% improvement in the S&P 500 and 4.9% in the Russell 1000 so far in 2012. While I discussed my bullish short-term view on small-caps in late December, today I want to share my thoughts on why small-caps should have a fantastic 2012.

Before I go on, I have to confess to being quite bullish on the market overall. I shared my initial views for 2012 in late October, and I believe that recent price action confirms my take on the market: The uptrend that began in March 2009 has now been tested twice and is intact. My thesis is simple: Challenging but widely known fundamentals, deep valuations and good technicals.

Before I try to support my thesis, here are some perspectives of the relationship between price for small-cap and large-cap. The Russell 2000 is the most widely used index for small-cap, and it represents the 2000 companies after the 1000 largest companies. The S&P 500 is the most widely used index for large-cap.

In the past 5 years, which correlates with the top of the last cycle, small-caps have performed only marginally better than large-caps (click to enlarge images):

Since the lows of 2009, small-caps have performed much better than large-caps, but not much better than a 1.2 beta would suggest:

While some may fear that they have "missed out", notice that since late July, when the markets began their free-fall, small-caps have lagged large-caps. The S&P 500 has cleared its July month-end level, while the Russell 2000 is still slightly lower:

Bull markets are typically good for small-caps relative to large-caps, though there have been exceptions, like the end of the 90s, when the S&P 500 blew away small-caps. This was a period of a sharply rising dollar and a very strong economy. While small-caps are typically more volatile (and, thus, market-directional) than their large-cap peers, it's not clear that you can make money in a rising market holding them instead of larger companies. Looking at some very long time-periods, small-caps have moved in sync with large-caps:

  • Since November 1981, the R2000 is up 947%, while the S&P 500 is up 944%
  • Since the end of 1994, the R2000 is up 213% compared to 186% for the S&P500

After adjusting for dividends, large-caps have outperformed small-caps over very long time-frames. So, the case I make won't be just because I am bullish! Still, a rallying market is likely favorable.

My optimistic view for small-caps relative to large-caps is based on what I expect to be a continuing environment of slow economic growth. I expect investor sentiment to improve as well. Here are the main drivers I think we will see:

  • More Engaged Retail Investor
  • Heightened M&A Potential
  • Domestic Focus
  • Less Focus on Dividends

"Joe Investor" has practically given up on stocks, especially over the past year, evidenced by massive outflows in mutual funds. Two bear markets in a decade, a flash crash in 2010 and the correction of 2011 have shattered confidence, but there are few alternatives for investment. The sure-thing yields zero, and income-producing assets have been picked over for the most part. Time heals all wounds, and there is nothing like positive momentum to change sentiment. If you don't agree that markets are improving, you won't buy this reason. While a rising market isn't always good for small stocks relative to large ones, I think that the current conditions of poor sentiment being reversed suggest it will be the case.

Companies are starved for growth, especially in light of slowing economic growth abroad. I expect that M&A will continue to improve, which should benefit smaller companies. One of the things I saw in 2011 was that public company costs have really escalated in recent years (SarBox) - there is a lot of EPS accretion from removing the duplicative costs. I recall a "20 PE" company that was really "15 PE" after removing these expenses. While I will discuss another aspect of tax law changes below, the potential end of extremely favorable LT capital gains treatment could help smaller companies on the acquisition front too, as privately-held companies seek to cash out.

In the past few years, the dollar has weakened and investors have sought companies with overseas exposure, which has benefited larger multi-nationals. With concerns over Europe likely to persist, we have already seen a renewed focus on domestically-oriented companies. Witness the frenzy over home-builders, for instance. While I believe that the lines aren't so distinct as investors might believe, it is clear that smaller companies do have more direct domestic exposure. I expect that this will benefit small-caps in 2012.

Finally, one of the reasons larger companies performed better in 2011 in my view was the focus on dividends. The S&P 500, with its more mature companies, currently yields more than 2%, while the R2000 offers about 1.3%. Perhaps this is a stretch, but the end of favorable tax treatment for dividends could impact demand for dividend-payers. More likely, interest rates should begin to rise as the year progresses, dampening demand for yield.

So, I have shared some reasons that I think small-caps should do better in 2012 relative to large-caps, reaccelerating a trend that began when the market bottomed in 2009 (if not in 2000). I have not included some big-picture ideas that are difficult to support, like the law of large numbers, which addresses growth challenges for companies the bigger they get. I do believe that smaller companies inherently have more growth potential. Another big-picture driver that I first shared in 2007 or 2008 is that smaller companies tend to have better balance sheets, and investors, who focus on PE without incorporating cash on the balance sheet, tend to overlook lower valuations than might be readily apparent.

This last point gets us to a great one: What does valuation have to say? As I have shared in comments on previous articles, discussing small-cap valuation presents a number of challenges. Many of the companies don't have accurate earnings forecasts, so the data is suspect. There is also the issue of looking at a single number to represent 2000 (or 500) companies. The market-cap concentration in the S&P 500 is much higher, and using market-cap weighted statistics works reasonably well. The Russell 2000 is more dispersed.

Large-caps are very cheap - that is easy to see and hard to dispute in my opinion. While I can find lots of smaller companies that are as cheap, the overall averages certainly don't show a massive undervaluation. Growth rates are different, and many smaller companies are not as efficient as larger ones (margins are very high now for big companies - not so for smaller ones). If a company trades at 100 PE and another is 10 PE, the "average" is a meaningless 55 PE. Still, it's important to know that the market-weighted trailing PE, for instance, in the S&P 500 is 14X (8.9X trailing EV/EBITDA), while it is 24X (and 10X) for the Russell 2000. I know from my own experience that this is meaningless, but people will bring it up. Alternatively, using P/TB, small-caps are cheaper (2.5X vs. 3.7X). My source of data is Baseline.

So, I hate to punt on what is clearly an important issue, but it's next to impossible to use a simple metric to describe small-cap valuations. At the peak in 2007, the market-cap weighted PE for the R2000 (according to my data) was 28X, so it is down. For the S&P 500, it is down somewhat too. It makes sense to me that small-caps do have higher PE ratios for the reasons I have mentioned: Better balance sheets, high "public company" expenses and more growth potential. I am not arguing to buy small-caps because they are "cheap" to large-caps, but I don't think that they are overly expensive.

Small-caps have started to outperform large-caps, but they remain depressed from year-ago levels. We are still early in the economic recovery, which suggests smaller companies have room to run fundamentally. I have shared other reasons for my favorable outlook. If you agree, you might want to shift your exposure by focusing on smaller companies. Alternatively, you can use ETFs such as the iShares Russell 2000 (NYSEARCA:IWM) or the iShares Russell Micro-Cap (NYSEARCA:IWC).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Want Big Returns In 2012? Go With Small Cap Stocks