The Market Presents Small (Cap) Opportunities

Disclosure: I'm long Anika Therapeutics, Hain Celestial Group, Drew Industries, Silicon Motion Technology, Home BancShares and Apple.

It's hard to argue that stocks as a group are not expensive. The price/earnings ratio, price/sales ratio, stock market/GDP ratio, Tobin's Q, cyclically adjusted P/E ratio--all of these are currently showing the market to be anywhere from slightly to significantly overvalued.

Given that we're now more than seven years into a bull market, that shouldn't be a big surprise. But what may surprise you is the source of that overvaluation.

Consider a few numbers. Since the end of 2005, my company has been tracking the valuation characteristics of the several thousand stocks in our database, a pretty good approximation of the U.S. market. Since then, they have traded at an average trailing 12-month P/E ratio of 19.1. Currently, the average is 21.3, representing an 11.2% premium over the long-term average. The average price/sales ratio over that 10-plus year stretch has been 1.74, meanwhile. Currently, it is 1.95. That's a 12.0% premium.

But a closer look shows a huge gap between the valuations of larger stocks and smaller stocks. Large-cap stocks are trading at a 21.8% premium to their long-term average using the P/E ratio, and a 24.7% premium using the PSR. Looked at another way, since the end of 2005, large-caps have been more expensive only 3.2% of the time using the P/E and just 0.1% of the time--yes, 0.1%!--using the PSR.

Small- and mid-cap stocks, meanwhile, are on average trading at P/Es 7.4% above their long-term average and PSRs 7.0% above the average. Since the end of 2005, they've been more expensive about 35% of the time based on P/Es and about 41% of the time using the PSR. Expensive? A bit. Wildly overvalued? No.

Put these figures together and you see that small-caps have been this cheap relative to large caps only 1.6% of the time over the past decade-plus based on P/Es, and just 8.6% of the time based on PSRs.

The graphic below shows that smaller stocks have been becoming more and more attractive compared to large-caps since 2011. A reading of 1.0 would indicate smaller stocks and larger stocks were trading at equal P/Es. (Keep in mind that small stocks typically trade at significantly higher valuations than larger stocks because they are considered better candidates for significant growth.)

P/E Ratio of Small- and Mid-Caps vs. Large-Caps, 2005-2016

Why The Gap?

I believe this has a lot to do with the swift rise of index funds. Smaller stocks are usually left out of the most popular index funds. As more and more investors have turned to index funds in recent years, it has created a self-sustaining cycle in which the money that goes into index funds goes primarily to larger stocks. Now, most of these funds' holdings are weighted by market capitalization; in reality, many of them give even more weight to the largest companies than would be merited based on market capitalization. When money goes into these funds, the big guys go up in price more than the smaller members of the index, causing them to gain even more weight in the index, which means new inflows will be even more disproportionally allocated to them.

The data shows just how top-heavy the S&P 500 index is: The top 10 holdings in the SPDR S&P 500 ETF Trust collectively have more weight in the index than the 300 smallest holdings combined, according to data from ETF.com; Apple alone has as much weight as the 100 smallest holdings combined.

This has led to mega-caps like Amazon and  Netflix having incredible runs that have made them expensive--in some cases, extremely expensive. Yes, these companies are producing strong growth. But not nearly enough to demand their huge prices. Would I be willing to pay a bit of a premium for these companies' economies of scale and competitive advantages? Sure. Would I be willing to pay ten times the price of a good, fast-growing small- or mid-cap? Nope.

With that in mind, here are a handful of smaller stocks that my Guru Strategies--which are based on the approaches of Warren Buffett and other investing greats--are high on right now. These companies are producing plenty of growth, and trade for reasonable valuations.

Silicon Motion Technology (SIMO) is a fabless semiconductor company that makes high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. Its products include mobile storage, mobile communications, multimedia systems-on-a-chip (SoCs) and other products.

Silicon Motion ($1.4 billion market cap) gets strong interest from my Peter Lynch-based model. The Lynch strategy considers it a "fast-grower"--Lynch's favorite type of investment--thanks to its impressive 39% long-term earnings-per-share growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate; in this case, the five-year rate is unavailable, so it is an average of the three- and four-year rates.) Lynch famously used the P/E-to-Growth (PEG) ratio to find bargain-priced growth stocks. Silicon Motion's 23 price/earnings ratio may seem pricey, but when we divide it by its long-term growth rate, we get a PEG of 0.6. Anything below 1.0 is acceptable to this model.

Lynch also liked conservatively financed firms, and the model I base on his writings targets companies with debt/equity ratios less than 80%. SIMO's D/E is less than 1%, another good sign.

Hain Celestial Group  makes organic and natural products under brand names that include Almond Dream, Arrowhead Mills, Celestial Seasonings, Garden of Eatin', Rice Dream, Robertson's and Rudi's Organic Bakery. The company has a market capitalization of $5 billion and it has taken in about $2.9 billion in sales over the past year.

Hain gets strong interest from my Martin Zweig-based model, which likes that its long-term EPS growth is high (23%) and driven by sales growth (25% long term). It also likes that EPS growth is accelerating--it jumped to 47% last quarter--and that Hain has a debt/equity ratio of 50%, less than half its industry average.

Home BancShares (HOMB) provides a range of commercial and retail banking and related financial services to businesses, real estate developers and investors, individuals and municipalities through its wholly owned community bank subsidiary, Centennial Bank. Centennial has locations in Arkansas, Florida and South Alabama.

Home BancShares ($3 billion market cap) has grown EPS at 31% clip over the long term. Last quarter, it increased EPS by 26% and sales by 28%, helping it earn high marks from my Motley Fool-based strategy, which is inspired by an approach detailed by Fool co-creators Tom and David Gardner. The strategy also likes Home's 33.4% after-tax profit margin, 0.61 PE-to-growth ratio, and $2.29 in per-share free cash flow.

Indiana-based Drew Industries is a supplier to the recreational vehicle and manufactured homes industries. Through its subsidiaries, Lippert Components, Inc. and Kinro, Inc., it produces a range of components, including windows, doors, chassis, chassis parts, bath and shower units, axles, upholstered furniture, awnings and slide-out mechanisms for RVs. It also makes components for modular housing, truck caps and buses, and for trailers used to haul boats, livestock, equipment, and cargo.

Drew ($1.8 billion market cap) gets strong interest from my James O'Shaughnessy-based model, in part because it has increased earnings per share in each year of the past half decade. The strategy also likes Drew's combination of strong momentum (12-month relative strength of 86) and value (1.22 price/sales ratio). My Lynch-based model also likes the stock, which sports a 21% long-term EPS growth rate and 0.94 PEG ratio.

Massachusetts-based  Anika Therapeutics  develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. Its therapeutic products help in the areas of orthobiologics, advanced wound care and aesthetic dermatology, surgery, ophthalmology, and veterinary services.

Anika ($625 million market cap) gets strong interest from my Peter Lynch-based model. It has grown EPS at a 38% clip over the long term and trades for just under 20 times earnings. That makes for a solid 0.52 PEG ratio. It also has no long-term debt.