Wall Street Week Ahead: Valuations may hurt small caps, despite job growth

February 6
10:59 PM 2015

The good news from Friday's jobs report may already be reflected in the prices of the smallest U.S. stocks.

With nearly all of their revenue coming from the United States, the companies in the Russell 2000 should be the most obvious beneficiaries of a growing U.S. economy.

Yet fund managers and analysts warn that small-cap stocks already trade at valuations high above long-term averages, even after significantly lagging large-company shares in 2014. This could put a cap on further gains.

"Small-cap companies have something of an advantage in this economy. But investors have figured that out," said Phil Orlando, chief equity strategist at Federated Investors in New York.

Companies in the Russell 2000 look expensive compared with their history, said Steven DeSanctis, an analyst at Bank of America Merrill Lynch, in a Feb. 3 note to clients.

The trailing price-to-earnings ratio of the index is at 22.7, which is 40 percent more than its long-term average of 16.2. Its price-to-sales ratio of 1.6 is nearly 67 percent higher than its long-term average.

High valuations already appear to be cutting in to returns, DeSanctis said. The Russell 2000 is up 11.9 percent over the last 12 months, compared with a 16.7 percent gain in the large-cap Standard & Poor's 500 index over that time. Year to date, both indexes are up less than 1 percent.

Still, Steven Raineri, the lead portfolio manager of the Franklin All-Cap Value fund, increased his stake in small-company stocks by 25 percent over the last year in part because of signs of improvement in the housing market and in consumer confidence. Overall, multi-cap fund managers increased their stake in small-cap stocks 10 percent over the same time, according to Morningstar data.

"We're happy if there's a disconnect and we can find companies we like at prices we're comfortable with," Raineri said.

He has been adding to his holdings in companies such as Gibraltar Industries Inc, a $500 million market-cap company that makes mailboxes and other products used in the construction of housing developments, and Griffon Corp, an $813 million market-cap company that manufactures garage doors and landscaping products. Both companies derive 70 percent or more of their revenue from the United States, according to Thomson Reuters.

Overall, in the last five years, 81.3 percent of revenue for Russell 2000 companies came from the United States, compared with 64.3 percent of revenue for S&P 500 companies, according to Bank of America Merrill Lynch.

Nonfarm payrolls increased 257,000 last month, the Labor Department said Friday, well above forecasts. The dollar index rose slightly more than 1 percent on the news.

Raineri said that he is more concerned about the dollar continuing to rise quickly than higher share prices for small-cap stocks. A rapid jump in the dollar could be a sign that investors are seeking safety, and could draw investors away from small-cap stocks, he said.

"If the dollar gets too strong too fast, it's going to be taken as a sign of the global economyweakening," he said.

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