Good Values Don't Necessarily Come in Small Packages Anymore

From a valuation standpoint, large-capitalization stocks are a pretty sorry lot these days. As earnings have fallen -- even for nontech names such as Wal-Mart WMT and Ford F -- the price-to-earnings ratios for many big companies have stayed uncomfortably steep, though prices have fallen far off their highs. It's no surprise that the average P/E of the S&P 500, home to many mega-cap stocks, is still hovering well above its historical average of 15.7.

What is a surprise is that small-cap and mid-cap stocks -- which many investors have recently viewed as better values -- look just as pricey, relative to their historical norms.

In short, small-caps aren't much of a bargain anymore. "They've now come back toward the norm," says Sam Burns, a research analyst at Ned Davis. "There are high P/Es everywhere across all caps."

The current P/E of the Russell 2000 , a common proxy for the small-cap market, is a sky-high 30.5, compared with the historical average of only 20.8.

That looks about as overvalued as the Russell 1000, an index of large companies. Its current P/E is 26.5, compared with a historic average of 18.4.

That's a marked turnabout from earlier this year, when small-caps looked like a steal relative to their big-cap brethren. In January, the average P/E of small-caps in the Russell 2000 was actually lower than that of the large-caps in the Russell 1000 -- the reverse of the usual situation. Small-caps typically trade at a higher P/E than large-caps, reflecting their potential for speedier growth.

Accordingly, the ratio of the average P/E of the Russell 2000 to the average P/E of the Russell 1000 has been 1.18 for about the past two decades, according to Ned Davis Research. Back in January, though, the ratio had slipped to only 0.85, indicating that small-caps were trading more cheaply than large-caps.

Sorry, No Bargains Here Current P/E averages are much higher than historical figures

* As of 7/31/2001. Source: Russell

In light of the strong relative values and the weak prognosis for bigger companies, investors have been heavily favoring small-cap issues this year. Year to date through July 31, investors poured $17.3 billion into small-cap funds. Meanwhile, they withdrew $2.3 billion from large-cap funds, according to Lipper.

As a result, though, prices of some small-caps have spiked upward. And because earnings of smaller companies also have held up better than big companies, small-cap P/Es have surged from their low levels earlier this year. The current ratio of small-cap to large-cap P/Es is 1.15, almost back to historical levels.

In other words, small- and mid-caps no longer look like value-priced bastions of sanity in relation to their expensive large-cap counterparts. If the market were to revert to historical averages at this point, says Burns of Ned Davis, stock prices would have to fall across all capitalization categories.

But investors shouldn't start yanking money out of small-cap investments. Even if they're not great values anymore, they look like solid investments for other reasons. For one thing, they're likely to suffer less in the market downturn than large-caps.

"Large-caps will probably get hit the worst vs. small- and mid-caps because they tend to be the most capital-intensive firms," says Andrew Clark, a research analyst for Lipper.

As their revenues fall and other capital sources dry up, big companies may have to burn cash at a faster pace than smaller outfits. "Think of the manufacturing firms and quasi-manufacturing firms which make up large stocks," Clark says. "Most recessions come about from declines in the manufacturing sector vs. the service sector, so large-caps will get [hurt worse]."

Another argument in favor of small-caps is that they typically lead the market in economic recoveries. "If you think that recovery is near, certainly, small-cap investments make a lot of sense, and maybe even mid-caps as well," says Clark.

The upshot: Don't harbor any illusions that you're getting a deal for venturing outside the large-cap market. That money has already been made. But that doesn't mean you should ignore the small- and mid-cap markets. It's a smart place to invest a piece of your portfolio, in anticipation of an eventual market rebound.