An Alternative to U.S. Small-Cap Equity

July 30, 2014 | David Hernandez, CFA, Director of Traditional Manager Search

This week we examine the valuation of developed non-U.S. small-cap equity (MSCI EAFE small-cap) compared to U.S. small-caps (Russell 2000). The chart displays the relative price-to-earnings (P/E) and price-to-book (P/B) ratios for the two asset classes. A lower number indicates the U.S. is more expensive compared to non-U.S small-cap stocks. Based on the historical averages for both P/E and P/B, non-U.S. equity looks relatively attractive.

Small-cap companies in the U.S. have performed well in this historically low interest rate environment. Now five years into the economic recovery, market participants expect a rate hike from the Fed to occur sometime mid next year. With U.S. small-cap stocks lacking extraordinary earnings growth, many investors are questioning their valuations. In the Eurozone and Japan, two areas that account for over 40% of the MSCI EAFE small-cap index, the economies are earlier in their respective recoveries and experts anticipate lower interest rates to persist in these regions, which should be accretive for equities in those markets. Investors looking to reduce their U.S. small-cap exposure should consider developed non-U.S. small-cap, given the accommodative central bank policies and relative valuations.