NEW YORK (The Street) -- Don't be fooled by their stellar run, small-cap stocks still have plenty of steam. But beware speculative biotech stocks.
That's the warning from fund managers, who said an explosion in biotech stock prices has raised the average valuation for small companies, obscuring rich opportunity in other sectors.
Small companies typically outperform the broader market in an economic recovery -- such as the current U.S. cycle -- with the Russell 2000 last year posting a 33% gain against 26% for the S&P 500.
Average small company outperformance jumped even more drastically since February, raising concern of stretched valuations after the 2013 index rally.
Some fund managers said less exposure of small companies to volatile emerging markets justifies the run, coupled with greater deal activity. For example, there were just four small-cap M&A deals during 2013 against the same number so far this year, Hodges Capital Management portfolio manager Eric Marshall noted.
Even so, the forward price-earnings ratio (PE) of the Russell 2000 is a sky-high 53 times now vs. 17 times for the S&P 500. This far outstrips the median PE for the Russell 2000 since 1995 at 30 times while the S&P 500 maintains its median PE since that period of 17 times. Put simply: Small caps appear very pricey.
Speculative biotechs yet to generate cash are a key driver behind this inflation, fund managers said. Biotechs now make up 4.8% of the small-cap index, up from 3.2% last year, and the largest increase in sector contribution.
Marc Roberts, Fenimore Asset Management small-cap fund co-manager, said this drags down average sectors earnings, obscuring good-value "gems" in other industries. A case in point: When companies without earnings are excluded from the index, the average forward small-cap PE drops to 22. "Those (biotech) investments are very speculative and there's a real bifurcation in the market," Roberts said in a phone interview. He pointed to the solid earnings of regional banks as a contrast, citing picks such as First NBC Bank (NBCB) -- a lender that is profitably run and trades at a reasonable valuation.