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Party's Over for Small Caps, Stop Drinking the Punch

NEW YORK (TheStreet) -- Small caps are due for a pullback with large companies poised to take the lead. 

That's the assessment of many fund managers, after a record run for the Russell 2000 since the credit crisis. Over the past year, the index posted 25% against 20% for the S&P 500, with small cap valuations pushed to dizzying heights.

Now, fund managers are questioning whether earnings will justify such bloated multiples, with many forecasting single-digit returns for small companies in 2014.

"There's not a lot of bargains to be had among small companies and I'm very nervous about valuations on an absolute and relative basis," Bank of America Merrill Lynch head of small cap strategy Steven DeSanctis told a media briefing Tuesday.

He noted the forward price earnings ratio stood at 20 to 21 times for the sector, with recent outflows from small cap mutual funds. Against this valuation expansion, small cap earnings growth was only around 10% last year. "We are not going to see earnings kick into high gear -- it was a mixed reporting season and volatility has ticked up," DeSanctis added.

His commentary reflects that of many fund managers, who almost uniformly point to biotech and select pharmaceutical small cap stocks as low-quality risky plays, with several of them yet to generate earnings.

Russell Investments index investment strategist David Koenig also noted the more domestic revenue focus of small companies, which may see them at a relative disadvantage against the backdrop of a global economic recovery.

On a sector basis, DeSanctis likes global cyclical stocks, such as select industrial and technology companies. He is neutral on financials, which are initially hard-hit by a rising rates backdrop but ultimately benefit from a stronger economy -- preferring small banks, asset managers and insurers to real estate investment trusts. The fund manager is also neutral on health care, energy and material stocks, preferring chemicals and housing stocks. On the flip side, he avoids utilities, consumer staples and consumer discretionary stocks, with the latter having rallied hard over the past year.

More broadly, fund managers note investors are rewarding companies that participate in M&A as a use of cash on their balance sheets, with the share prices of both acquirers and targets often rising in recent deals. A tough backdrop for organic growth has seen a resurgence in M&A as macroeconomic uncertainty recedes, yet executives remain reluctant to invest heavily in new staff or infrastructure.

"We are underweight small caps for 2014 and it's mostly a valuation argument," DeSanctis said, ranking large, then mid-cap stocks above small companies for one-year return prospects.

The exception to this scenario would be a backdrop where the domestic economy improved faster than expected, causing an acceleration in earnings growth that would favor small caps over their large cap peers, the fund manager said.

 

-- By Jane Searle in New York

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