The Russell 2000 index is the most widely embraced measure of small-cap performance, and its returns this year have been downright dismal. So far, the iShares Russell 2000 ETF (IWM -0.61%) has tumbled more than 11% in 2014, prompting some to speculate that the Russell's performance led to the broader drop in the S&P 500 (SPY -0.38%) this past month.
If slumping small-cap stocks contributed to the broad market retreat, then their recovery may similarly lead to big-cap peers finding their footing. That raises an interesting question: Is it time for long-term investors to consider buying small-cap stocks in their portfolios?
Valuing small cap
The most common tool for measuring valuation is the P/E ratio, which divides price by earnings per share. It's a quick and easy way to determine how much investors are paying for each dollar of earnings.
In the case of the Russell 2000, eliminating companies with negative earnings per share that would skew the results gives us a P/E ratio of 20.7. That's a bit high given that between 1998 and 2013 the Russell 2000's average forecast P/E has been 17. Additionally concerning is that despite falling prices, the Russell's P/E ratio has actually increased since Q2 as EPS estimates have fallen more quickly than stock prices. Overall, valuation suggests that the Russell 2000 isn't cheap and that value investors may want to consider individual small cap companies instead. One that might be worth a look is Quality Systems (NASDAQ: QSII), a maker of health care IT solutions that is not only trading at a forward P/E that's lower than the Russell 2000, but that is also expected to see its EPS grow by 25% in the next year.
Past as prelude
After crunching price data since 1979, the Stock Trader's Almanac discovered that small-cap stocks lag large-cap stocks in summer, but outperform them in winter. Because the findings are based on 35 years of history, it's hard to argue that seasonality is a fluke. However, to make sure that seasonality has held up over the past decade, I calculated monthly returns for the Russell 2000 and S&P 500 since 2004 and confirmed that winter has typically been kinder to small cap investors.
Source: Author's calculations.
Since the spread between small and large cap returns was at its widest since 1998 in September, investors may want to pay particular attention to small cap seasonality this year. After falling -2.55% in 1998, the Russell 2000 rallied 21.26% in 1999.
Investors interested in individual small cap stocks that have solid seasonality into year end may want to consider machine-to-machine communications system company CalAmp (CAMP -4.59%). CalAmp boasts intriguing solutions like telematic devices, which are used by insurers to monitor and offer discounts to safe drivers, and its shares have gained in eight of the past 10 Q4's for a median return of more than 20%.
Profiting from fear
In 1994, Warren Buffett wrote in his annual letter to shareholders: "If they [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."
To see whether or not investors are too fearful, I compiled short interest for 600 widely traded small-cap stocks and discovered that the average days to cover these shorts is near post-recession peaks. Historically, small-cap short interest hits a high in the fall and declines in winter.
Source: Author's calculations.
If typical investor behavior repeats this year, short covering by speculators may help propel the Russell 2000 higher. That may already be happening given that the Russell 2000 has gone from lagging the S&P 500 to leading it this month. One individual small cap stock with high short interest that may be worth considering is Trex (TREX 0.23%). Trex is a leading manufacturer of wood-alternative decking and it's beat analyst earnings estimates in three of the past four quarters, yet short sellers are still sitting on more than 17 days to cover short.
Putting ducks in a row
Although the average expected EPS growth for small-cap stocks has slid a bit this year, Russell still reports that the research firm I/B/E/S expects the long-term EPS growth rate for the Russell 2000 to be 13.72%. That's hardly anemic and it compares favorably to I/B/E/S 11.52% long-term forecast for the large-cap Russell 1000.
Despite valuation casting doubt on small caps, other evidence suggests that small-cap stocks may offer opportunity. If that's true, we may want to remember that long-term investing is a better bet than short term trading. After all, despite enduring the great recession, the Russell 2000 has still gained 117% since 2003.
