Small Caps Are Trading at a Massive Discount to Large Caps

There are still deals in today's market.

Yes, despite the incredible run we've seen... with the overall market hitting new highs... and certain stocks jumping hundreds of percent... you can still find value opportunities right now.

In fact, you can find that in a large portion of the overall market. That's because small-cap stocks have been lagging their larger peers.

While the S&P 500 Index has hit new all-time highs, small caps have yet to fully recover from their March bottom.

Small caps are now trading at one of the largest discounts to large caps in decades. It likely won't stay that way for long, though.

Small caps could soar much higher to try and close the gap. That means big gains and big outperformance could be on the way.

Let me explain...

There are many ways you could look at a valuation gap between areas of the market. Today, we'll use the price-to-book (P/B) ratio.

This gives us a quick look at how much you're paying for a company's assets. The higher the P/B ratio, the more expensive the stock is. And a spread in P/B ratios between assets can highlight a valuation gap.

Today, small caps trade for a P/B ratio of just 2.0 based on the benchmark Russell 2000 Index. That's much cheaper than the S&P 500's P/B ratio of 3.8.

Even more, this is one of the largest gaps we've seen in recent years. Take a look...

The discount of small caps to the S&P 500 sits at 46% based on this measure. And the gap this year is larger than any we've seen since 2001.

Buying back then would have led to solid outperformance over large caps in the following years. From October 2002 through October 2007, the Russell 2000 rallied 161%. Meanwhile, the S&P 500 was up just 111%.

You'll probably notice that small caps have historically traded at a discount to the S&P 500. There isn't even a 0% line on the chart above, which means they've never been more expensive than large cap stocks over this date range.

That's fine though. Because the discount is usually much smaller than what we see today.

Since 1999, the average P/B discount has been around 27%. And from 2004 to 2013, there were several years when that discount was even less. So while we can continue to expect a discount, we shouldn't expect one this large to last long.

Small caps will likely break back out to new highs in the coming months. And they will likely begin outperforming larger stocks in the process, closing the valuation gap.

If you want to buy small caps, you can easily do so with the iShares Russell 2000 Fund (IWM). This simple fund tracks the Russell 2000 Index, the benchmark for small-cap stocks.

These stocks are incredibly cheap today compared to the overall market. But history tells us that this won't last. Expect a big move in these stocks in the coming months.

Good investing,

Chris Igou

Further Reading

"When it comes to extreme wealth creation, almost nothing can compare to being an owner of a small company that grows large," Matt McCall writes. And right now, a handful of small companies stand to soar as their innovations change the way we live... Read more here: This Investing Advantage Could Be the Secret to Massive Wealth.

When it comes to investing in small-cap stocks, massive gains don't happen overnight. You need to have a strategy if you want to be successful. That's why Matt explains the "coffee can" approach to making venture capital-like gains... Get the full story here: This 'Coffee Can' Trick Could Help You Get Rich in Stocks.

Market Notes
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Today, we’re checking in on a major player in the global fight against COVID-19…

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As today’s chart shows, TMO has rallied about 90% since bottoming in March, recently hitting a fresh all-time high. As demand remains strong for its testing products and instruments, Thermo Fisher should remain in an uptrend…