Valuations may hurt small caps, despite job growth

Sat Feb 7, 2015 2:56am EST
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By David Randall

NEW YORK (Reuters) - 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 .TOY 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 (BAC.N: Quote), 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 .SPX 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 FRAVX.O, 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.   Continued...

A Wall Street sign is pictured in front of the New York Stock Exchange, open during Winter Storm Juno, in the Manhattan borough of New York January 27, 2015. REUTERS/Carlo Allegri