Description

“We looked back over several decades of valuations and covered 3,000 largest companies in the U.S. For Russell 1000, stock number 1 to 1000, right now we’re in about the 38^th percentile over our valuations. In the past when we’ve been at these valuations levels it’s been up 10% over the next year. It’s a different story for the small caps. Russell 2000 is stocks number 1001 to 3000. It’s in the fifth percentile. It’s been cheaper 95% of the time over the last several decades. And when it’s been here in the past, the year forward return has been negative 3%.  

                                                                                   - Joel Greenblatt on CNBC, Jan 14, 2014  

Overwhelming top down numbers (and bottom up anecdotal evidence) suggest that small caps today are priced to perfection.

Russell:

The Russell 2000 is constructed by taking the largest 3,000 companies in the U.S. and then removing the largest 1,000 names.  The largest weighting in the RTY is less than 50bps, yet the index as a whole has more than tripled since the 2009 bottom and risen more than 50% since the start of 2012.  The top 5 largest companies in the RTY are below. 

Russell Top Five Look Through:

Of the 5, only 4 had positive earnings over the past 12 months and excluding ISIS the group has a trailing P/E of 161x as well as a trailing P/B of 9.0x.  In comparison, the top 5 SPY members average P/E is 21x and the P/B is 5.6x (with those 5 representing 11% of the index).  The same data from the Nikkei (best performing major market last year) is average P/E of 32x and 5.9x P/B (with those 5 representing 26% of the index).   

We could pick on all five of the largest RTY members’ valuations but athenahealth is the easiest because they show the highest P/E and P/B.  Today they reported $2.6 million in GAAP net income for the full year 2013 on a (now) $6 billion market cap. The company highlights “pro-forma non-GAAP EBITDA” and the CEO constantly mentions Amazon and the “long term” (Alan Shortall at Unilife has comically taken the same playbook – ignore the short term fundamental performance of the business and focus on the long term R&D spend). The sell-side describes athena as “a fusion of Saas, mobile, social, and crowdsourcing rolled into one” and raised its target price to $181 based on 9.1 revenue multiple (apparently a bargain in the SaaS universe).  They just reported a “beat” so I’m sure these revenue multiples will be going up.

 Unfortunately, athenahealth is not an isolated “bottoms up” example of the current froth today – as any recently retired short only manager will tell you, the market is littered with them.

 The market as a whole shows the index trades at “just” 22x trailing P/E when excluding negative earnings, and it also trades at a price to book of 2.4x.  However, of the 2000 companies in the RTY there are 591 companies (or ~30%) that are losing money.  

Strangely, the largest Russell 2000 ETF player with over $27 billion in assets – iShares – shows a 30x P/E and 4.35x P/B for the indices. They also exclude negative earnings and P/E ratios over 60 are set at 60 but even still you get a 33% increase in P/E and 82% in price to book.  

To add more confusion to the mix, Bloomberg’s weighted P/E for the Russell is 47x.  In addition, we put together our own database and calculated an unweighted TTM P/E of every stock with a P/E below 100 (so excluding negative and extremely large P/E ratios – removing the most expensive 30% of the market), and it still came out at 24x.

Bloomberg shows that the forward P/E has increased over 55% since the third quarter of 2011 (see below) and that’s assuming massive earnings grow over the next 12 months.

Leuthold Group did a comprehensive report in November on small caps (they believe small caps trade at a 40% premium to the S&P – the highest in history) that is worth checking out. A few highlights include their observation that the normalized PE for is 29.4x and a point away from the late 1990’s all-time high.

They also point out that in these situations there is the potential for a meaningful drawdown based on past data once the market cracks.  On average the market has fallen ~35% in similar situations.  

Going back to P/B, Goldman also points out the extreme value to show that P/B has expanded one standard deviation above long term averages during the last two years. 

As far as other respected opinions on small caps, GMO is predicting a -5% annualized return over the next 7 years on small caps, while Value Line writes that their “median appreciation potential gauge” measure “fell to a 45-year low” meaning “projected upside has not been this poor since 1968.”  They also point out that this was the peak of small caps last time.   

Catalyst