The End of the Small Cap Boom

Small-capitalization stocks have been big winners, relatively speaking, since before the turn of the century. Small caps, as a group, have done much than their large-company brethren. Over the past 12 years through March 19, Standard & Poor’s 500-stock index, which is oriented toward stocks of large companies, returned an annualized 1.6%, and the small-company Russell 2000 index gained an annualized 4.6%. (All returns in this article are through March 19.)

Don’t bet on that trend continuing. The 12 years ending in March 2011 marked the longest period of small-cap dominance since market record-keepers started tracking such things in 1926.

Just like everything else in the markets, cycles of small cap and large cap dominance tend to get carried to extremes. Then, when almost no one expects it, the trend reverses.

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In the late 1990s, investors couldn’t get enough of large-cap-growth stocks, particularly in the technology and telecom sectors. Small-cap managers, especially those who specialized in stocks of small, undervalued companies, performed poorly even as the big-cap indexes soared. Many of those managers lost clients and some of them lost their jobs, too.

Now, the market has had a dozen years to correct those imbalances -- and create new ones.

Just look at price-earnings ratios (share price divided by earnings per share). In January, the median P/E of small-cap stocks was a record 25% greater than the median P/E of large-cap stocks, according to the Leuthold Group, a Minneapolis investment research firm. The previous record small-cap premium, set in 1983, was only 10%. As of March 1, small-cap P/Es were at a 19% premium to large-cap P/Es.

Small-cap stocks are, plain and simple, overpriced. On average, Leuthold says, small caps have traded at a 7% P/E discount to large caps.

What’s more, the tide is already ebbing for small caps. Over the past 12 months, the S&P 500 returned 12.6%, compared with a 6.9% advance for the Russell 2000.

Once one type of stock begins to excel it tends to lead for years. On average, cycles of large-cap dominance have lasted six years, Leuthold says. During those periods large caps nearly doubled the returns of small caps on average.

Even, the shortest period of large-cap dominance, in 1937 to 1939, lasted more than two years, and large caps returned 36% more than small caps. The longest, from 1946 to 1957, lasted 11 ½ years, during which large caps nearly tripled the returns of small caps.

Where are the bargains? They’re hiding in plain sight: They’re the giant mega-cap stocks -- the Apples, the ExxonMobils, the Googles, the Pfizers, the Wal-Marts of the world.

Based on analysts’ earnings estimates for 2012, the biggest 50 U.S. stocks trade at an average P/E of 11.6. Large caps, the biggest 300 companies (including the 50 mega caps) sell at an average P/E of 13. Small-caps, meanwhile, change hands at an average P/E of 16.

Not impressed by the numbers? Consider the fundamentals. Because of demographics and advances in technology, developing nations are likely to remain the fastest-growing part of the global economy for years to come. Giant companies, far more than small fry, are the main beneficiaries of rapid development in emerging markets.

The ability to obtain credit at attractive rates is also a big plus for large companies. In the aftermath of the financial crisis, banks remain squeamish about extending credit to even the highest-grade borrowers. But the biggest companies hardly need banks. They can issue stock and bonds to investors. Plus, most big companies have record amounts of cash -- ready to deploy as soon as they see demand rising for their products and services.

Finally, in a global economy still beset with outsized risks, blue chips possess more shock absorbers than small caps. Small caps typically live and die based on one or two product lines. They are inherently riskier than large caps.

What to buy? If you like to keep your costs low, consider Vanguard Large-Cap ETF (VV). The exchange-traded fund, which charges just 0.12% annually, gives you exposure to the nation’s largest companies. The average market capitalization (share price times number of shares outstanding) of its holdings is $41 billion, a smidgen higher than the S&P 500’s. And the average P/E of the fund’s holdings is 12 based on estimated earnings for the coming 12 months.

If you favor an actively managed fund, consider Vanguard Dividend Growth (VDIGX). This fund charges just 0.34% and sticks to high-quality companies that have a long record of raising their dividends annually.

Another fine choice is Yacktman Fund (YACKX). Co-manager Don Yacktman has put up great numbers for decades by focusing on the cream of the blue chips.

Steve Goldberg (bio) is an investment adviser in the Washington, D.C., area.