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written by Jody Chudley
For the past decade, the market has been dominated by large cap growth stocks.
Between December 31, 2012, and December 31, 2022, the Russell 1000 Growth Index (which is made up of large cap growth stocks) outperformed the Russell 2000 Growth Index (which is made up of small cap growth stocks) by nearly 5% per year.
Given this long-term outperformance from large cap stocks, you won’t be surprised to learn that – right now – small caps offer an attractive value proposition.
The ratio of the Russell 2000 (which is composed of small cap stocks) to the Russell 1000 (which is composed of large cap stocks) is currently at a 22-year low. We haven’t seen small caps this inexpensive relative to large caps since the turn of the century.
Interestingly, the last time the ratio hit this level was one of the best moments in history to pick up small cap bargains.
Beginning in 2001, small caps outperformed large caps by more than fourfold over the following 13 years.
Also, it’s important to note that small cap stocks aren’t cheap only relative to large caps. They’re cheap on an absolute basis as well.
With a forward price-to-earnings (P/E) ratio of 12.6, small cap stocks, as represented by the S&P SmallCap 600 Index, have rarely been less expensive.
The only two times this index has traded at a lower forward P/E ratio in the past 20 years were at the bottom of the financial crisis in 2008 and during the COVID-19 crash in March 2020.
Those were two other moments when buying small caps paid off incredibly well.
The case for small caps is already convincing, yet there is even more data that supports stocking up on small caps now.
Earlier this year, the Russell 2000 Index declined in value over four consecutive months. This is an extremely unusual occurrence.
Since the Russell 2000 was created in 1984, it has gone down in four consecutive months only eight times.
And the returns for the index coming out of these drops have been exceptionally strong. One-year returns have averaged 24.7%, three-year returns have averaged 21% and five-year returns have averaged 16.8%.
The recent four-month decline of the Russell 2000 suggests that small caps could be ready for another long run of strong performance.
While large caps are rather expensive at the moment, small caps offer an almost historically attractive value.
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