MW Are small-cap stocks cheaper than large caps? Yes - if you ignore this one key fact.

By Mark Hulbert

Leaving money-losing companies out of P/E calculations makes the Russell 2000 look more attractively priced

More than 40% of Russell 2000 companies are money-losing. This alters its price-earnings ratio.

The small-cap Russell 2000 RUT trades at a big discount to the large-cap S&P 500 SPX. Or it fetches a big premium. Everything depends on the data source.

In fact, small caps are now significantly more expensive than large caps.

I point this out to counter an emerging narrative that, because smaller stocks have declined so much in recent months, this sector is now undervalued and where bargain-hunters should look.

While there undoubtedly are some undervalued companies among the thousands of smaller stocks on Wall Street, the sector as a whole is not cheaper than the large-cap sector, even though small caps have lost far more than the overall market and trade solidly in bear-market territory.

Consider the price/earnings ratio for the Russell 2000 index, which is the standard benchmark for the small- and midcap sectors of the U.S. market. Based on trailing 12-month earnings, its P/E currently stands at 32.1, according to the Wall Street Journal. That's almost 50% higher than the 22.1 P/E for the S&P 500, the standard benchmark for the U.S. large-cap sector.

But many other data sources paint an entirely different picture. Exchange-traded fund provider iShares, for example, reports that the Russell 2000's trailing 12-month P/E is 15.2 - less than half what the Wall Street Journal is reporting. The reason that the iShares' number is so much lower is that, unlike the Wall Street Journal, the firm excludes from its calculation companies that are losing money, artificially lowering the index's P/E.

(iShares acknowledges that it doesn't include unprofitable companies in its P/E calculation, footnoting its reported P/E by acknowledging that "negative P/E ratios are excluded from this calculation." Furthermore, iShares is not alone in calculating P/E ratios this way.)

In many situations, overlooking companies that are losing money wouldn't have a huge impact. But not in the case of the Russell 2000. According to FactSet, no fewer than 837 companies in that index lost money over the past 12 months. That's more than 40% of the index's constituents.

This large proportion of unprofitable companies is consistent with a trend I've written about before: An increasingly larger proportion of corporate profits is earned by just the largest companies. Thomas Noe of Oxford University and Geoffrey Parker of Dartmouth College, who identified this trend as far back as 2000, call it a "Winner-Take-All" economy. To the extent this trend continues, of course, it will be increasingly important not to ignore unprofitable companies when calculating an index's average P/E.

Focus on small caps with low P/E ratios

Just because the small-cap sector as a whole is not undervalued doesn't mean there aren't attractive individual small caps. There are many ways to identify undervalued stocks. A good place to start is to exclude money-losing companies and those that trade at high price-to-earnings ratios.

To appreciate the value of focusing on small-cap stocks with low P/E ratios, consider the long-term performance of a hypothetical portfolio of such stocks, as calculated by Dartmouth professor Ken French. From July 1951 through 2024, it beat a portfolio of small-cap high P/E stocks by 5.1 annualized percentage points.

To construct the list of stocks in the table below, I started with Russell 2000 companies that are also currently recommended for purchase by any of the investment newsletters my auditing firm monitors. I then narrowed the list to include those with the lowest forward P/Es (according to FactSet) and those that also pay a dividend.

The 15 stocks are listed in order of their forward P/Es. They include KB Home (KBH), American Eagle Outfitters Inc. $(AEO)$, Winnebago Industries Inc. $(WGO)$, Hancock Whitney Corp. $(HWC)$ and First Merchants Corp. $(FRME)$.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

More: Here's where top investment newsletters are finding the most undervalued stocks

Also read: The Treasury market is tipping its hand. Stock investors aren't seeing it.

-Mark Hulbert

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April 18, 2025 07:45 ET (11:45 GMT)

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