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Relative Value and Relative Returns

Valuation differences between large and small-cap stocks lead relative returns

William Hester, CFA
July 2006
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How long does it take value to be realized? Over what period does the market turn from being a voting machine into a weighing machine, as Ben Graham so eloquently put it? There are no simple answers, but when valuation divergences get large enough, and investors are patient, the pendulum will often swing back.

One noticeable divergence has been the performance of small and mid-cap stocks relative to large caps over the past six years. During this time the valuations of small companies have generally more than doubled, while the largest company P/E ratios have been halved. But large caps started from a point that was more than double their long-term averages. Today, the S&P 500's P/E ratio of 17.5 sits noticeably above its long-term average (about 14) and steeply above its long-term median (about 11). Smaller company valuations are significantly higher. S&P's mid-cap benchmark trades at 21.5 times earnings and the Russell 2000 P/E ratio is currently at 36, more than twice that of the S&P 500.

It is this divergence - between the relative valuation of large and small companies - that looks unusually wide. With both groups starting from high absolute valuation levels, it's difficult to argue for strong returns for either group. But the data do suggest that, in terms of relative performance, there may be better days ahead for large-cap companies (if not gaining more than small caps, then maybe at least falling less).

Relative Value

Comparing the relative valuations of large companies versus small companies over long stretches of time is not simple. Russell's benchmark was born in the late 1970's, and the S&P 600 is even younger. A good alternative to get some perspective on the valuation of the small-cap market is to look at the companies in the S&P 500 that carry the least amount of weight. It turns out that the smallest companies in the S&P 500 are, in fact, a good proxy for the small-cap market. One reason is overlap. A majority of the 30 smallest companies in the S&P 500 are current members of the Russell 2000 Index. The performance of the smallest companies in the S&P 500 is also more closely tied to small-cap performance than with the large-cap index. Since 1978, the average yearly return in the 30 smallest companies in the S&P 500 has had a higher positive correlation with the Russell 2000 than with the big-cap index.

The chart below shows a ratio of the P/Es of large companies versus the P/Es of small companies. The small-cap P/Es were calculated by forming a portfolio of the 30 smallest companies in the S&P 500 at the end of each year and then taking the median P/E from each of these portfolios. The series of large-cap P/Es was created in the same way using the largest 30 companies by market capitalizations. The graph below shows the ratio of these median P/Es since 1970.

A rising blue line indicates that the valuation of large-caps is climbing more quickly than the valuation of small-caps. The two peaks on the chart are the two-tiered 'glamour stock' markets of the early 1970's and the late 1990's, where large companies commanded steep valuation premiums. In 1973, the median large company was trading at nearly twice the valuation level of the median small company. In 1999, large-cap companies traded at almost 1.5 times the multiple paid for smaller companies.

For the first few years of the 1990's, the improvement in the valuations of large-caps relative to small caps (indicated by a rising line) was entirely warranted. Even in 1994 big companies were trading at a 20 percent discount to smaller companies. From those levels large companies began an impressive multi-year rally in valuation multiples. Once the market's excitement for blue chip stocks peaked, the valuation roles switched again, and small capitalization stocks took the lead. Over the past several years, small cap stocks have moved from depressed valuations to speculative ones. Large companies are back to trading at about 80 percent of the valuation of smaller companies, a relative valuation that hasn't occurred in more than a decade.

Although it's never easy to identify turns in the market, it appears likely that large-cap stocks will earn a better return (or at least smaller losses) than small cap stocks over the next several years. The tendency for relative returns to follow relative valuations is shown in the chart below. The blue line is, once again, the ratio of the P/E of the 30 largest companies in the S&P 500 versus the P/E ratio of the 30 smallest companies. The violet line (left scale) measures the difference in performance between small cap stocks and large cap stocks over the subsequent 5 year period (the line ends in 2000 with the last 5-year return calculation). An elevated violet line indicates that small-cap companies outperformed large-cap companies over the following 5-year period.

In the early 1970's, large-cap valuations were extreme relative to small-cap valuations. Both groups experienced sharp losses during the 1973-1974 bear market, but large-caps were hit harder. A portfolio of large companies fell 4.2 percent a year from 1972 through 1977. Small companies fell just 1.3 percent a year during that period. Once the bear market cleared, small companies went on to rise more than 25 percent a year, almost double the gain of large caps.

You can also see the round-trip that large-cap investments took beginning in the early 1990's. From 1992 through the end of the decade, large-cap companies decidedly outperformed smaller companies, partially helped by large-cap companies moving from extreme relative undervaluation to extreme overvaluation. The trough in the violet line in 1994 represents the strong relative 5-year performance for large caps beginning at these low relative valuation levels. The subsequent (and recent) small-cap rally beginning in 1999 began from a relative valuation level not seen in more than 25 years. The elevated violet line in 2000 shows that small caps performed strongly versus large caps from 2000 through 2005.

Isolating Large and Small Company Performance

You can also compare the valuations of either large or small companies with the overall P/E on the S&P 500. Here, the largest stocks in the S&P 500 are trading at a more favorable valuation level relative to the index than usual. With a P/E of 17.5 for the S&P, and a median P/E of 14.8 for the large company portfolio, the largest companies are trading at roughly a 15 percent discount to the overall index, the most significant discount in relative valuations since the end of 1987.

The median P/E of the large company portfolio usually sits above the P/E of the index. When it has fallen below the index P/E - which is where it is now - relative returns have favored large companies. For example, a portfolio of large companies bought at the end of each year where their median P/E was below that of the market would have earned average annual returns 10.2 percent above S&P 500 returns over the following five-year period (helped by the late 90's run-up in large companies). In contrast, portfolio of large companies purchased when they traded at a 25 percent premium to the market performed .3 percent a year worse than the market over the next 5 years.

The same strategy applied to small companies displays a similar return pattern. The current median P/E of the small portfolio is 18.9, or 1.08 times the S&P's P/E (even this figure seems low with the P/E of the Russell 2000 at twice the S&P's P/E). Buying the 30 smallest companies in the S&P 500 when the median P/E ratio of that portfolio was below the index earned 4.2 percent annually above S&P 500 returns over the next 5 years. Buying smaller companies when they traded at a 25 percent premium trailed the market by .4 percent a year over the next 5 years.

Keep in mind that these returns are relative to market returns. Essentially they represent being long the size portfolios while short the index. In 1972, small stocks were cheap relative to large companies, but that didn't save them from participating in the 1973-1974 bear market and ending up with multi-year annualized losses. And small companies were still cheap relative to large companies at the beginning of 2002, but that didn't save them from losing 20 percent that year, as measured by the Russell 2000.



The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).

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