Small caps remain at a near-record discount relative to larger counterparts, presenting potential for returns despite a recent rally that led to expanded multiples across the board, according to Bank of America analysts.
A February rally saw multiples expand across the board, with small caps leading the charge.
The Russell 2000 forward P/E surged to 15.3x from 14.3x, aligning it with its historical average multiple for the first time since late 2021. However, relative to larger counterparts, small caps remain at a near-record discount, presenting an opportunity for potential returns.
While equities have become pricier overall, the relative forward P/E of small versus large remains 26% below average, indicating potential for 9% annualized returns over the next decade for the Russell 2000.
Bank of America analysts suggested that this disparity could persist due to risks associated with higher interest rates, but sees upside potential for small cap multiples driven by accelerating earnings growth.
Their analysis also underscores the attractiveness of value stocks within both small and mid-cap sectors. Value stocks continue to appear historically cheap compared to growth stocks, with small cap value trading at a forward P/E of 12x, below its historical average of 13x.
This, combined with evidence of an accelerating profits cycle, strengthens Bank of America's preference for value over growth.
Additionally, Bank of America's quant framework highlights opportunities within sectors, ranking Financials as the top small cap sector, followed by Consumer Discretionary and Industrials. Conversely, defensive sectors such as Utilities, Staples, and Health Care rank lower.
One particular relative value opportunity identified is within the small cap Discretionary sector compared to Staples. Bank of America notes that small cap Discretionary trades at a relative multiple 30% below average on P/E, presenting an attractive proposition for investors.