Some corners of the market remain relatively undervalued © REUTERS

Smaller US-listed companies are trading at a steep discount compared with their larger peers, highlighting how corners of the market remain relatively inexpensive despite the big rally from the depths of the coronavirus crisis.

The S&P 600 gauge tracking the smallest stocks by market value on the index provider’s composite US equities barometer is priced at 14.5 times expected earnings over the next year, according to FactSet data. The valuation is well below the 21.3-times for the benchmark S&P 500 index, which tracks America’s corporate behemoths such as Apple, Facebook and Tesla.

Line chart of Forward price-to-earnings ratio showing US small-cap stocks trade at steep discount to larger peers

That leaves the S&P 600 price-to-earnings ratio at about 68 per cent of the S&P 500, among the lowest levels since the dotcom bubble at the turn of the millennium. Small-capitalisation value stocks, companies that are considered to be priced inexpensively when compared with corporate fundamentals like book value, are trading at an even steeper discount as investors have piled in to quickly-growing companies instead, according to William Heaphy, head of William Blair’s value equity team.

The valuation gap has grown even as the S&P 500 and 600 have both more than doubled from their coronavirus-induced lows last March, showing how investors need to pay richly to scoop up shares in the biggest US groups.

Small-cap stocks’ more alluring price tag relative to large cap groups, which on the whole are priced at highly elevated valuations compared with long-term trends, has some analysts and investors sniffing out opportunities.

“Despite our forecast for a flat year for the S&P 500, we are still bullish on pockets of the market, including small caps,” analysts at Bank of America said in the Wall Street bank’s 2022 outlook. “Small caps are more domestic, more exposed to the services spending recovery, bigger beneficiaries of capital spending and ‘reshoring’, and are inexpensive [compared with] large caps.”

Mark Sherlock, head of US equities at asset manager Federated Hermes, echoed BofA’s sentiment, noting that “while Covid-risk still lingers, we believe the underlying economy is strong.” 

“This backdrop should benefit company earnings, particularly in small and mid-capitalisation companies which have a higher domestic exposure and a — typically — more local supply chain,” he said.

Investors interested in the UK, meanwhile, would do well to look beyond the underperforming large-cap FTSE 100, said Charles Hall, head of research at Peel Hunt. Companies in the mid-cap FTSE 250 are “far more representative [of the UK economy] and have done much better”.

Line chart of S&P 600 forward p/e ratio as % of S&P 500 showing Small-caps trade at cheap levels compared with large-caps
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