The Real Divergence is Within Small-Caps

August 21, 2014 11:44 AM

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The Real Divergence is Within Small-Caps

All year long we’ve heard about the divergence between the Russell 2000 and the S&P 500. Today I want to take a closer look at the divergence within the small-cap space itself, specifically between the Russell 2000 and the small-cap value stocks, represented by Vanguard’s VBR. 

These two indices have basically moved in lockstep for the past few years until this March, when we saw a distinct change in character; IWM fell 10.9% through May while its value counterparts fell just 3.7% over the same period. YTD the small-cap value ETF is up 7.23% while IWM is up only 0.28%.

So, what’s going on?

The real story here is valuation. The small-cap value stocks are trading at  22.5x trailing 12-months earnings and 9.8x price/cash flow. The Russell 2000 is significantly more expensive, trading at 41.8x trailing 12-months earnings and 13.7x price/cash flow.

You’ll notice from the graphic that the sector holdings are very similar. However, if we take a closer look under the hood, we find that biotech’s were a big reason why IWM has stunk up the joint relative to VBR. Biotech’s are the second largest sub-industry in IWM, making up 5% of the index while they are just the thirty-fourth biggest sub-industry in VBR, making up just 1% of the index. Many of these companies don’t have earnings and even the adjusted P/E ratio of 83 for the S&P small-cap biotech index is well into nosebleed territory.

It’s impossible to pinpoint when market participants are going to shun expensive areas as there are a plethora of factors that affect investor psychology and the weight with which they drive decision making is never exactly the same. We know that valuations do matter, the tricky part is knowing when that’s going to be.

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