Earnings Estimates – Small Caps Undervalued?
As you can see from the chart below, the forward PE of Russell 2000 firms is below the forward PE of Russell 1000 firms. At the end of October, the forward PE of Russell 2000 firms was 14.9 and the forward PE of Russell 1000 firms was 15.8.
This ratio is the lowest in 15 years and it’s below the average since 1978. This ratio seems to work in cycles, implying there is more to fall even though it’s below average. There are two important points to recognize. First, small caps have a lot of debt and rising rates are making that debt tougher to roll over. Because of that, the discount small caps are trading at might be justified.
The second point is the Russell 2000 PE ratio doesn’t include firms with no earnings which means the real PE is much higher.
It’s not ideal to buy highly indebted firms which aren’t profitable as interest rates are increasing.
I’m not bullish on small caps for the next year. If the tariffs are ended, the multinational stocks will rally while small caps won’t. American growth is slowing just like the rest of the world, ruining the potential outperformance of small caps which are usually domestically oriented.
Earnings Estimates – Review Of Q3 Earnings Season
With 445 S&P 500 firms reporting earnings, it’s fair to say Q3 was amazing, but future estimates are disconcerting. As you can see from the table below, EPS growth has been 32.24% and sales growth is 9.35%. That’s peak earnings growth if the results are maintained. Sales growth is 0.96% away from Q2. The EPS surprise rate is 6.89% with 80% of firms beating estimates. That’s above the 3 year average of a 5.17% beat rate with 73% of firms beating estimates.
Unfortunately, EPS beats are the least important part of earnings season. Revenues and guidance are far more important. The EPS growth makes stocks cheaper, but future estimates determine current stock prices. As you can see, 62% of firms beat sales estimates which is way below the Q2 rate of 75% and the Q1 rate of 74% which gave us inklings growth would continue. The 62% beat rate matches the 3-year average.
