US Small Cap Valuation Historically Low

International | Dec 05 2023

T. Rowe Price notes US small caps have only seen a PE as low as it is now twice this century.

By Tim Murray, Capital Markets Strategist at T. Rowe Price

As of November 21st, the forward price to earnings (P/E) ratio for the S&P600 [small cap] Index stood at 12.6x, a level well below historical norms for the index.

In fact, since the turn of the millennium, we have only seen the S&P600 dip below 13x twice. Once was in 2008 during the Global Financial Crisis and the other was in 2011 when sovereign debt concerns weighed heavily on stock market valuations across the globe.


January 1, 2000, through November 21, 2023.

Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. S&P 600 index.

In addition to low valuations, small cap stocks offer an improving earnings outlook, as forward earnings estimates have recently stabilized.  

Small cap earnings have been on a bit of a roller coaster ride in the wake of the COVID-19 pandemic. From January 2020 to May 2020, forward earnings estimates fell by an astonishing -45%. But over the subsequent two years, estimates skyrocketed—cumulatively increasing by 212% as the pandemic shutdown was replaced by a robust re-opening of the US economy.

However, that period of prosperity was replaced by yet another downturn—one that looked as if it could turn ugly earlier this year.

Fortunately, the U.S. economy has proven more resilient than expected in 2023—which has translated into earnings estimates stabilizing in June and July, and subsequently showing signs of upward momentum as we enter 2024.

Unfortunately for small cap investors, cheap valuations and an improving earnings outlook have recently been overshadowed by concerns about higher interest rates, which pose a notable challenge to many small cap companies for three primary reasons.

The first is higher leverage. Small cap companies collectively hold higher debt burdens than large caps, as illustrated by a comparison of net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratios. Small cap net debt is more than 4 times as large as EBITDA, while the large cap ratio is only 1.42.

The second reason is thinner margins. While operating margins for small caps have been gradually increasing over the last 20 years, they stand well below those of large caps, at 13% versus 21%. This means that as interest costs increase, small caps have less of a buffer before profit margins turn negative.

The final reason is nearer-term maturities. Around 64% of the outstanding debt for small cap companies matures within the next five years, versus only 44% for large caps. This means that interest costs will increase more quickly for small caps, as company bonds that were issued when interest rates were at extremely low levels will need to be refinanced at higher rates sooner.

United States small cap stocks offer a compelling combination of relatively attractive valuations and an improving earnings outlook. As a result, T.Rowe Price's Asset Allocation Committee holds an overweight position to US small cap equities.

However, small cap companies are likely to prove more sensitive to higher interest rates than large cap companies. For this reason, we believe it is preferable to invest in this asset class via actively managed portfolios with a higher-quality bias.

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