Does the discount on small caps make them a buy?

Simplistic reasoning is rarely useful in the stock market and can sometimes be the enemy of common sense.

“If investors start selling the ‘Magnificent Seven’, this will trigger a rotation of investments into other sectors,” notes Amy Zhang of Alger (*).

“It is important to analyze things from a fundamental perspective. If we look at the price-to-earnings (P/E) ratio, small-cap stocks included in the S&P SmallCap 600 were trading at the end of last year at a significant discount compared to stocks in the S&P 500. There may be several reasons to explain this valuation gap between small and large caps.”

In reality, the opposite is true. If investors begin buying small caps, they will inevitably sell the mega-cap tech stocks as part of an asset class rotation. Many—professionals included—analyze the P/E ratio simply in terms of “expensive” or “cheap,” which is misguided.

The P/E ratio is, first and foremost, an indicator of earnings quality.

If your P/E is low and your earnings are declining with no sign of improvement, your stock price will fall. And you will still have a low P/E. If your P/E is high and your earnings are growing with positive prospects, your stock price will rise, and you will continue to have a high P/E.

There is a reason why small caps have lower P/E ratios: their earnings are less robust.

For reference, within the Russell 2000 index:

- 697 companies are unprofitable.

- Only 954 companies are expected to report earnings growth this year.

- Only 924 companies have shown quarter-over-quarter earnings growth.

- Just 697 companies have beaten expectations on both revenue and earnings.

- 659 companies disappointed with their latest results.

For small caps to rally and emerge from their bear market, we need to see a broad improvement in earnings outlooks. Only then will P/E ratios improve and prices rise accordingly.

This does not mean that some small caps won’t see their prices increase—only that it is misguided to generalize across the entire group. The mere existence of a valuation discount has never been, and never will be, a buy signal.

(*) Source of quotations:: https://allnews.ch/content/interviews/les-small-caps-se-traitent-avec-une-dcote-marque-par-rapport-aux-valeurs-du-sp (*) Source of quotations: