Is small beautiful?
By Mark Hulbert, CBS.MarketWatch.com
Last Update: 12:01 AM ET March 3, 2004
ANNANDALE, Va. (CBS.MW) - Are small-cap stocks undervalued?
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Answering this straightforward question turns out to be surprisingly complex.
I was nevertheless prompted to ask it by the front-page article in the March issue of Eric Kobren's Fidelity Insight. Kobren argues that, while small caps are not as undervalued relative to large caps as they were in the late 1990s, they are not overvalued either.
In other words, relative to large caps, the small caps are fairly valued.
"We believe that small caps (and mid caps) will continue to outperform large caps in the near future, but the differences will shrink. The huge disparity in valuations that developed in the late 1990s has largely been erased."
The historical record provides strong support for Kobren's argument. Nonetheless, I was amazed when reviewing that record how the conclusion one reaches about small-cap valuations depends on how much history one analyzes.
Over the past five years, for example, small caps have outpaced large caps by a huge amount, far in excess of their historical rate. To measure the extent of that outperformance, I turned to the database maintained by finance professors Eugene Fama and Ken French (of the University of Chicago and Dartmouth).
For the five years ending Dec. 31, according to the professors, the average small cap outperformed the average large cap by 11.8 percentage points per year on an annualized basis. Since the 1920s, in contrast, the historical average difference in these two groups' return is around 2 percentage points a year.
So if we were to stop our analysis here, we'd have to conclude that small-cap stocks have gotten significantly ahead of themselves - and therefore overvalued.
But what if, as Kobren suggests, the small caps' impressive performance over the past five years came after they had fallen significantly behind the large caps?
In other words, what if the small caps merely were catching up?
So I focused on the past 10 years instead of the past five. That's the time period reflected in the accompanying graph.
Over this longer period, as you can see in the graph, small caps have beaten the large caps by a more modest amount. On an annualized basis, the difference in these two groups' 10-year returns turns out to be 3.5 percentage points -- less than the 11.8 percentage points by which the small caps beat the large caps over the past five years, but nevertheless nearly double the long-term average.
So, from this 10-year perspective, small-cap stocks have more than overcome their under-performance of the mid- and late 1990s. Though to a lesser extent than when focusing on five years, this 10-year perspective also suggests than small caps are ahead of themselves - and overvalued relative to the large caps.
How, then, about a 20-year perspective? The data now paint a significantly different picture: Cumulatively over the past 20 years, there has been essentially no difference between the returns of the average small cap and average large cap.
In other words, the average small-cap stock's impressive performance in recent years has still not made up for its underperformance of the previous 15 years.
Looked at from this 20-year perspective, therefore, small cap stocks are undervalued relative to large caps. They still have a long way to run before returning to its long-term pattern of outperforming large caps by an average of 2 percentage points per year.
The bottom line?
Pick a period, any period: Will the future be more like the past five years, the past 10, the past 20, or the past 80?
Statisticians tell us that the best bet is on the continuation of the pattern that reflects the greatest amount of data - the 80-year period, in other words. That means that our best guess is that, in the future, small-cap stocks will outperform large caps by an average of 2 percentage points per year.
With that in mind, I queried the Hulbert Financial Digest database to locate those small-cap stocks that are most recommended by investment newsletters.
I imposed a fairly strict limit on how big these companies could be - a market cap of less than $200 million - since the academic research on small-cap stocks has found that the bulk of small-cap outperformance is attributable to the issues with the smallest market caps.
I instructed the HFD computers to tell me which stocks, in addition to satisfying that criterion, were also recommended by three or more newsletters and did not trade on the Nasdaq bulletin board.
Five stocks emerged:
Symbol Company
ALTH Allos Therapeutics
EVOL Evolving Systems
NENG Network Engines
OMNI Omni Energy Services
PESI Perma-Fix Environmental Services
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Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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