Valuation Bifurcation: Are Small and Mid-Caps Overpriced?

 In Market and Investment Insights

Investors are segmenting stocks into a bifurcated market. Our mid- and small-cap portfolio managers share the opportunities and risks.

Key Takeaways

  • Many small- and mid-cap stocks with recession-resistant business models or exposure to secular growth trends trade at excessive valuations.
  • Stocks of companies facing near-term headwinds have experienced multiple compression,even some of those beating earnings expectations and raising earnings guidance.
  • The market backdrop calls for a selective approach among stocks tied to secular trends. Stocks in which the market is taking a myopic, near-term focus may offer opportunities for investors.

With the current bull market reaching now the longest in history, clients frequently ask whether stocks are overvalued. It’s a tougher question to answer than it might seem at face value. The short answer is…it depends where you look.

Through the end of the third quarter, investors have been segmenting companies into a bifurcated market, split between two camps we simply call the “haves” and “have nots.” This market dynamic has existed for most of 2018, but as the valuation gap between the two camps continues to widen, we believe it presents both opportunities and extreme risks for investors. Valuations within both groups deserve closer inspection:

The Much-Loved “Haves”

The “haves” camp includes two types of companies: those with proven, recession-resistant business models and companies tied to tantalizing secular growth themes such as medical innovation or Software-as-a-Service (SaaS). There’s a strong case for interest in both categories, as they are well insulated from the concerns du jour of the market: tariffs, rising rates, geopolitical uncertainty or questions about where we are in the economic cycle.

Within the “haves” camp, multiples have steadily expanded, particularly for the stocks tied to secular growth trends. Over the past year, we’ve seen multiples for these companies climb the ladder of the income statement, first trading on a healthy multiple of earnings, then to a healthy multiple of EBITDA and, finally, to sometimes absurdly high multiples of revenue. The chart below showing performance of the stocks with the highest P/E’s and negative earnings demonstrates the market’s preference for these stocks so far this year.

High Flyers Flew Higher in Q3

Stocks with negative earnings and the highest P/E ratios have outperformed the broader small- and mid-cap markets both in the third quarter and rest of 2018.
The chart divides the Russell Midcap Growth and Russell 2000 Growth indices into quintiles, based on their P/E ratios and shows the performance of each group. Quintile five has the highest multiple, while quintile 1 has the lowest. The chart also breaks out performance of companies that have yet to produce earnings.

There are abundant examples of excessive valuations within the “haves” camp, but to put color around the issue, take the example of one cloud software company that is yet to produce earnings and instead trades at 14x its projected 2020 revenue. Using a discounted cash flow model1, the company would need to compound annual revenue at a 20% rate over the next 15 years and maintain 50% incremental margins to justify its stock price today. If it compounds at a still impressive 15% rate, its stock price is currently 40% overvalued.

The stock could be considered even more richly valued. If a company isn’t profitable yet, accounting standards don’t require it to include unvested shares in the share count. When the company is acquired or achieves a profit, those unvested shares are counted. Throw in the unvested shares and the current stock price of the company listed above discounts a 24% revenue growth rate for the next 15 years.

We believe a lot can go wrong in these companies’ nascent development that could cause the market to question the aggressive earnings assumptions implied in such lofty valuations. Similarly, many established companies with economically resilient businesses would have to see their earnings growth break out to a wholly new pace to justify current valuations.

The Unloved “Have Nots”

The valuation backdrop for the “have nots” is starkly different. This camp generally includes select companies within the industrials, materials and consumer discretionary sectors. The companies typically face some type of near-term headwind such as tariffs or regulatory pressure that the market simply can’t look past. In many cases, the “have not” stocks experienced multiple compression even though they are producing better-than-expected earnings growth and are revising future earnings guidance upward.

As just one example to highlight the “have not” dynamic, we’ve seen an industrial component manufacturer grow its earnings and ratchet up guidance this year, only to see it’s multiple compress from 13x earnings to 11x earnings. In our view, nothing has fundamentally changed for the business. The earnings outlook is improving and the company is delivering. But the stock has been assigned to valuation purgatory because the capital expenditures outlook for one of its smaller end markets has diminished.

Valuation Gap Could Persist

We won’t try to predict when the tide will turn for valuations within the “haves” camp. Exuberance and momentum outpace rationality and discipline in every market cycle, and such periods can last for a while. But we believe a day of reckoning will come.

In the meantime, we believe investors should take prudent approach to the valuation bifurcation within both small- and mid-cap markets. Some stocks tied to secular growth themes may still be good investments but we recommend a selective approach, closely analyzing the competitive advantages of these companies relative to their valuations. Investors should assess the strength of the management team, the size and duration of a company’s growth potential and the size of their addressable market.

Meanwhile, digging into stocks within the “have not” camp; we understand concerns that the U.S. may be late in an economic cycle but we believe the market has failed to account for the balance sheet strength of many industrial companies, for example, and their ability to withstand and even grow through a cycle. There are a number of industrial companies where new management teams are improving operations and deploying technology to improve margins. These same companies have prudently used a long period of low rates to dramatically improve their debt profile. For many of the “have nots,” we believe the near-term clouds aren’t as gray as the multiples suggest.

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1This discounted cash flow model assumes a 10% discount rate.

Growth and Value investing each have their own unique risks and potential for rewards, and may not be suitable for all investors. A growth investing strategy typically carries a higher risk of loss and a higher potential for reward than a value investing strategy. A growth investing strategy emphasizes capital appreciation, a value investing strategy invests in “value” stocks, which can continue to be inexpensive for long periods of time and may never realize their full value. No investment strategy can ensure a profit or eliminate the risk of loss.

Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.

Russell Midcap® Growth Index reflects the performance of U.S. mid-cap equities with higher price-to-book ratios and higher forecasted growth values.

Russell 2000® Growth Index reflects the performance of U.S. small-cap equities with higher price-to-book ratios and higher forecasted growth values.

C-1018-20264 04-15-19