Managing Valuation Risks As Market Multiples Rise In Mid- & Small Caps

On February 1, 2007, WisdomTree launched its U.S. Earnings family of Indexes. Over the course of this nearly 11-year live track record, many clients have asked us why we chose to weight these Indexes by earnings.

What’s happening in U.S. equities today provides an environment for a better answer than any we have been able to provide thus far. I have recently addressed the topic of managing valuation risk in large caps. Below I focus on the mid- and small-cap segments of the U.S. market.

2017 has seen the Bloomberg Dollar Spot Index drop by 8.53%,1 creating a positive tailwind to the earnings of U.S. multinationals—predominantly larger companies. We see below that this has manifested in large caps outperforming both mid-caps and small caps in 2017.

For definitions of indexes in the chart, visit our glossary.

Even though large caps have been outperforming in 2017, if we instead focus on valuation, a similar step-wise progression exists in the opposite direction. The two large-cap Indexes (the S&P 500 Index and the Russell Top 200 Index) have trailing 12-month price-to-earnings (P/E) ratios of slightly below 22.0x. Both the S&P MidCap 400 and the Russell Midcap Indexes had P/E ratios of between 24.0 and 25.0x. The small caps were the most expensive, with the S&P SmallCap 600 Index trading at about 29.0x and the Russell 2000 Index trading slightly below 50.0x.2

The Difference of Negative Earnings

A P/E ratio of close to 50.0x stands out and probably leaves many thinking that there may be some sort of mistake or miscalculation. However, this draws out an important distinction between the Russell 2000 and the S&P SmallCap 600 Index. In the case of the S&P Index, there is a requirement for positive generally accepted accounting principles (GAAP) net income prior to companies gaining initial inclusion.3The Russell 2000 Index has no such requirement4, and on a trailing 12-month basis, we’ve tended to see approximately 20% of the weight of the Russell Index in firms with negative earnings.5