By Rupert Hargreaves at ValueWalk.
Bank of America, Merrill Lynch's August small-cap strategy report, warns of high valuations across the small-cap universe but also notes that quality small-caps are now trading at their lowest valuations in more than 15 years.
Small-cap, high price
The small-cap universe currently trades at a forward P/E of 19x earnings, which is in the top quintile of valuations on a historical basis. BoA notes, this kind of excessive valuation usually leads to a period of poor performance.
Small-cap biotech stocks are now at their highest weight ever in the Russell 2000 and Russell 2000 Growth at 7.2% and 13.4%. The non-earners represent more than 14% of the core benchmark and even more so in growth (20%).
Due to excessive valuations and a high weighting of non-earners in indexes, BoA believes that there is limited upside for small-caps the remainder of 2015. However, the bank's analysts believe that smaller, higher quality names will outperform going forward. This thesis is based on historic trends.
Based on data dating back to 1999 when small-caps have posted weaker than median performance, high-quality earners in the universe have topped lower quality by 16.1%. What's more, the largest small caps, as defined by highest market cap quintile, topped the lowest by 15.7%. So based on these figures, the largest small caps with high-quality earnings should outperform throughout the rest of the year.
Volatility also has an effect on small-cap performance. Now that the Federal Reserve is looking to being hiking interest rates, volatility could return to the markets and based on historic data, according to BoA, the largest high-quality small-caps outperform in volatile markets.
For value investors, the really interest part of BoA's report on small-caps is the cheapness of quality small-caps. Quality is now more attractive on a price to sales and price to book ratio that at any other point since 2000.
Looking at the valuations of high ROE vs low ROE small-cap stocks, quality is very attractive with price to sales and price to book ratios across the small-cap sector trading more than 38% below their trendlines and the lowest since the early 2000's. Smaller stocks have led the rally since the market bottomed in 2009. However, larger small caps are trading at a premium versus their small-cap brethren as a result of bigger being better so far this year.
Small-Cap Stocks
Ten high-quality small-cap stocks picks
So, where should investors be looking if they want to capitalize on this valuation anomaly? Screening the Russell 2000 for ideas, BoA has earmarked ten stocks from five sectors. All qualifying names have a market cap. in excess of $1 billion, have reported an ROE in the top quintile of the small-cap universe and ranked well on the bank's other quantitive models.
1. American Axle & Manufacturing Holdings, Inc.
- Forward P/E: 7.4
- P/B: 5.2
- ROE 5yr: 8.9%
- Yield: 0.0%
2. Bloomin' Brands, Inc.
- Forward P/E: 17.5
- P/B: 4.7
- ROE 5yr: 10.2%
- Yield: 0.9%
3. Deckers Outdoor Corporation
- Forward P/E: 14.0
- P/B: 2.2
- ROE 5yr: 15.0%
- Yield: 0.9%
4. New Residential Investment Corp.
- Forward P/E: 11.8
- P/B: 1.5
- ROE 5yr: 10.8%
- Yield: 11.3%
5. Globus Medical, Inc.
- Forward P/E: 26.8
- P/B: 3.8
- ROE 5yr: 18.4%
- Yield: 0.0%
6. Surgical Care Affiliates, Inc.
- Forward P/E: 29.7
- P/B: 3.0
- ROE 5yr: 17.3%
- Yield: 0.0%
7. Team Health Holdings, Inc.
- Forward P/E: 29.7
- P/B: 3.0
- ROE 5yr: 17.3%
- Yield: 0.0%
8. Swift Transportation Company
- Forward P/E: 14.7
- P/B: 4.7
- ROE 5yr: 79%
- Yield: 0.0%
9. Trueblue Inc (NYSE:TBI), Inc.
- Forward P/E: 16.1
- P/B: 2.0
- ROE 5yr: 10.5%
- Yield: 0.0%
10. Tessera Technologies, Inc.
- Forward P/E: 19.4
- P/B: 3.0
- ROE 5yr: -9.6%
- Yield: 2.2%
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