Looking for growth? Small caps may not be answer

For the first time since the economic recovery began in 2009, S&P 500 companies might see earnings growth turn negative in Q3 2012.

By The Fiscal Times Sep 25, 2012 11:56AM
Image, Stock market report, copyright CorbisBy Suzanne McGeeThe Fiscal Times logo

If the analysts polled by Thomson Reuters have called it correctly, the third quarter of 2012 will be the first quarterly period since the economic recovery began in 2009 in which earnings growth rates for companies in the Standard & Poor's 500 index will turn negative.

With only a week left to run before companies close their books on the third quarter, it makes sense to ask whether the S&P 500 tells the full story of corporate profits -- and whether there might be some pockets of above-average growth to be found outside the universe of 500 of the largest U.S. publicly traded stocks.

At first glance, the answer to the latter question appears to be "yes." In recent quarters, midcap stocks -- as represented by the S&P Midcap 400 index -- have generated a higher level of earnings growth than either the megacaps in the S&P 500 or their smaller counterparts, the small-cap stocks that populate the S&P Smallcap 600 or the Russell 2000 index, according to data from Thomson Reuters. Both small and midcap stocks have beaten the S&P 500 companies, and they are likely to continue to do so in the second half of the year.

The only significant change is that while midcap stocks have been posting the largest gains in earnings, going forward, analysts expect the smallest companies to fare best when it comes to earnings growth. Specifically, while the Thomson Reuters forecast calls for a 2.11% decline in earnings for the S&P 500 and suggests that the Midcap index will eke out a 2.87% advance in earnings (compared to a 12.56% gain in the second quarter), companies in the S&P Smallcap index are poised to report earnings that are up 5.39% from year-ago levels, and those in the Russell 2000 index will see an increase of 7.88% in their profits.

The pattern remains intact for fourth-quarter projections, with the S&P Smallcap index forecast to generate nearly double the rate of earnings gains expected for the S&P 500, and analysts calling for the Russell 2000 to generate nearly three times as great an increase in profits for the final quarter of the year.

That pattern is very logical, when you stop to think about some of the factors that the largest companies have cited when they have cut their earnings forecasts and warned investors about expecting too much from them in the coming quarters. A primary concern has been what has been going on in Europe, and their exposure to European markets; secondarily, these businesses have said that the robust U.S. dollar -- when measured against the value of other major currencies -- has made doing business more difficult and created some foreign exchange issues that will impact profits.

Add to that uncertainty surrounding Chinese growth, and the result is a big earnings headwind for the S&P 500 companies, all but a handful of which are likely to have significant exposure to overseas markets. On average, however, smaller companies are less vulnerable to these issues: they are less likely to be exporters of either goods or services.

"The pockets of strength and growth that we're seeing are coming from consumers at home in the United States," says Jim Russell, chief equity strategist at US Bank Wealth Management. "We see it in housing and autos, and retailers saw a very strong back to school shopping season; that’s a bit of a gauge of consumer sentiment as it's the second most important time of the year for retailers after the holiday season."

If you're a growth-oriented investor, looking at data like this might have you salivating at the prospect of owning stocks that are likely to beat the S&P 500 this year and next, as the bigger companies struggle to deal with the global economic slowdown. Not so fast, Russell cautions.
"Eventually we are all linked. In the aggregate, Europe is a larger economy than is the United States, and if it continues to be quasi-recessionary for an extended period of time, absolutely every company is going to feel the gravitational pull of that trend."

Translation: Don't count on being able to find a place to hide from the global storm in smaller-cap stocks; eventually, as bigger companies react to the slower growth and contraction in their bottom lines by cutting costs, the impact will filter through to the U.S. consumer and companies dependent on them for their financial wellbeing.

Look at small-cap and mid-cap stocks, and identify those companies most likely to demonstrate that kind of above-trend earnings growth captured by the Thomson Reuters aggregate estimates. But while you are doing that, you might want to ponder two other factors: first, the fact that valuations on those companies already reflect the probability of better earnings growth, while these stocks, on average, pay much smaller dividends than do those in the S&P 500. Earnings growth rates don't tell the whole story, in other words.

Today, the S&P 500 trades at 14.4 times earnings for the last four quarters (in other words, on a trailing basis) and at 13.5 times what companies in the index are likely to earn over the coming 12 months (or on a prospective basis). As you move down the market capitalization spectrum, you climb higher on the valuation curve: the S&P Midcap has a trailing price-to-earnings ratio (P/E) of 16.8 and a forward/prospective P/E of 15.3; the S&P Smallcap's trailing P/E stands at 19.3 and its prospective P/E at 16.5.

The most richly valued of them all is the Russell 2000, where that forecast premium earnings growth rate translates into a premium valuation: 23.8 on a trailing basis and 18.8 time forward earnings expectations. Given this kind of pattern, the odds of finding a bargain are rather slim.

Now, throw in the yield data. Jim Russell points out that the yield on the S&P Midcap stands at 1.42%; that of the S&P Small cap at only 1.29%. In contrast, the yield on the S&P 500 is 2.01%. "Yes, the earnings growth rate will be smaller, but the dividend yield is well above the ten-year average," says Russell. That's one reason he isn't recommending clients chase after higher earnings growth rates.

"Caution will return to the market when the current excitement abates a bit, and large cap stocks will then be the place to be. As long as it remains hard for companies to look into the future and understand what might be coming next, the perceived level of risk is going to have a great deal of impact on returns."

Investors wary of the impact of Europe on the bottom line of their investments can still find companies in the S&P 500 and even the Dow that have minimal exposure to global pressures, such as Verizon (VZ), the telecommunications concern. Verizon also boasts a premium yield of 4.5%, and gives investors a way to play the smartphone phenomenon.

True, it also has an outsize valuation -- it trades at about 45 times trailing earnings, more than triple the P/E on the S&P 500. If you don't mind a lower yield and some degree of overseas exposure, an alternative might be Cisco Systems (CSCO); its yield is nearly 3%, well above the S&P 500 average, while its trailing P/E is 12.7, below that of the index. Moreover, like many S&P 500 companies, Cisco is sitting on a cash mountain and has shown a willingness to raise its dividend and return cash to its shareholders.

There's no perfect solution here: investors, for now, at least, are facing the need to make a tradeoff between growth and safety. Given that the stock market rallies that we have witnessed over the last three years or so have been unpredictable in their length and breadth, safety --especially when you can combine it with an above-average yield that may climb higher still --may be the least unappetizing of the available options.

Suzanne McGee is a columnist at The Fiscal Times. Subscribe to The Fiscal Times' FREE newsletter.

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