Over the longer term, small cap stocks have managed to put up some impressive numbers versus their larger peers. In fact, since 1926, small caps have returned nearly 16.7% in annual average total returns- besting the large cap S&P 500 by roughly 5% over that time. That’s because the firm’s minuet size leaves plenty of growth on the table. After all, it’s far easier for a company with a $500 million market cap to double than say Microsoft (NASDAQ:MSFT) and its $291 billion market cap.

However, even with the long term outperformance, small caps can be prone to periods when they are overvalued.

Given just how far the asset class has surged over the last year or so, we could be entering one of those times. For investors, trimming some of their exposure could prove fruitful.

Getting A Bit Pricey

With the Federal Reserve still pumping plenty of cheap money into the system, investors continue to load up on risk assets. Adding positive data from the strengthening economy and it’s no wonder why small cap stocks have been on a tear this year. The benchmark iShares Russell 2000 ETF (NYSE:IWM) has jumped roughly 29% since the beginning of the year and is up 5.4% over the past three months. That contrasts to the 21% gain for the venerable S&P 500.

That quick surge now has some analysts saying that small caps are getting too expensive to overweight.

According to analysts at Bank of America (NYSE:BAC), with the Russell now moving past 1100, small cap values are now trading at well above historical highs. At that mark, the index is now trading at a price-to-earnings ratio of just above 18 for its 2013 forecasts. The long-term average for the company size is around 14.9. Analysts at the bank also conclude that once small caps hit a P/E of 19, there is generally a hard reversion to the mean.

Digging into individual sectors, small-caps the news is much worse. Aside from tech- which is helping keep the average down- many industries are trading at P/E’s in the 15 to 30% above normal range. For example, small cap consumer stocks- like Red Robin Gourmet Burgers (NASDAQ:RRGB) -are especially pricey. Consumer discretionary and consumer staples names are trading at forward price-to-earnings ratio 23% and 30% above long term averages, respectively.

All of this echoes similar finds from analysts polled by Thompson Reuters when looking at the small cap based S&P 600.

The Potential Plays

Given that the warning bells are starting to sound in small cap land, investors may want to consider hedging or lighting up their exposure to sector- especially considering just how far they have come in 2013.

Aside from trimming, investors may want to take a look at the ProShares Short Russell2000 (NYSE:RWM) as a hedge. The ETF shorts the broad benchmark index- without using leverage- in order to provide the inverse of the Russell’s returns for a single day. That could help cushion the downside as small caps revert back to historical averages. For those investors who really want to bet heavily on a small cap crash- the triple leverage Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA) can be used.

Another option could be to focus on small caps that pay dividends. Not only to dividends help cushion on the downside, those firms that pay tend to more fiscal sound and are currently cheaper than non-payer. For those looking for single ticker access to dividend-focused small-caps, ETF issuer WisdomTree (NASDAQ:WETF) has the most exposure to the theme. The WisdomTree SmallCap Dividend ETF (NYSE:DES) tracks 623 different firms including imaging firm Lexmark (NYSE:LXK) and Consolidated Tomoka Land (NYSE:CTO). Expenses are a cheap 0.38% and the ETF yields 2.75%.

Finally, the easiest solution may just to get big. The Guggenheim Russell Top 50 Mega Cap (NYSE:XLG) bets on the 50 largest U.S. firms, while the iShares S&P 100 ETF (NYSE:OEF) extends that out the 100 biggest stocks. Both ETFs could rise as investors shift money from expensive small caps to cheaper large caps.

The Bottom Line

Given their torrid run, small caps may finally be getting expensive. That could signal some down days in the months ahead. For investors, shift some of the focus away from the sector or hedging their holdings may seem prudent. The previous ideas are great ways to do just that.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.


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Tickers in this Article: IWM, RWM, DES, TZA, OEF, XLG, WETF, LXK, CTO, MSFT, RRGB, BAC

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