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Are Small-Cap and Midcap Stocks Really Cheap?


Even a P/E ratio of 27.1 could be reasonable if the earnings of small-cap and midcap stocks were growing rapidly. However, that is not the case. Despite a surprisingly strong economy in 2023, the average company in the index reported lower earnings compared to the previous year. According to FactSet data, nearly 800 companies in the Russell 2000 incurred losses over the past 12 months.

In conclusion, while it may seem that small-cap and midcap stocks are attractively priced, a closer look reveals some underlying factors. The exclusion of unprofitable companies in the P/E calculation and the decreasing portion of earnings available to smaller companies suggests that the low price tag may not accurately reflect the actual value.

The Growth of “Winner Take All” Economy

Research conducted by Kathleen Kahle of the University of Arizona and Rene Stulz of Ohio State reveals a concerning trend in the income distribution of U.S. publicly-traded corporations. The study found that the share of total income earned by the top 100 most-profitable firms has been steadily increasing. In 1975, this percentage stood at 48.5%, but by 2015, it had soared to 84.2%. This means that the thousands of corporations outside the top 100 are left to contend with mere crumbs.

According to a theory proposed by Thomas Noe of Oxford University and Geoffrey Parker of Dartmouth, this shift towards a “winner take all” economy is not accidental. They argued that the rise of “network effects” in the digital age would lead to the dominance of large companies within industries.

Over the past five years, the Russell 2000 index has consistently underperformed the S&P 500 SPX index, which is primarily composed of large-cap stocks, by an annualized margin of 5.9 percentage points. If this winner-take-all phenomenon continues its ascent, we can anticipate the Russell 2000 to continue trailing behind, potentially by even larger margins. This holds true despite misleading headlines that highlight attractively low P/E ratios for smaller stocks.

More: 5 Essential Questions for Investors in 2024

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