Small Cap Earnings will lead the way

Earnings for smaller companies over the next 12 months will double that of larger capitalization companies as they continue to increase their operating leverage and generate the kind of top-line sales growth that has proven elusive to the behemoths, analysts’ estimates show. This makes the group a buy even if price-earnings ratios continue to fall, according to UBS.

"We expect small-cap multiples to contract over the next several quarters causing the valuation gap with larger stocks to narrow,” said UBS strategist Jonathan Golub in a note to clients today. “However, we expect smaller stocks to outperform as this multiple contraction should be more than offset by stronger earnings results."

Earnings for small companies will increase by 31 percent in the current quarter and the fourth quarter, according to UBS figures calculated using Standard & Poor’s data. On the other hand, larger companies will post earnings growth of 20 percent and just 12 percent over the next two quarters respectively, analysts predict.

Golub points out that small cap profit margins took five years to recover during the last recovery, while large cap margins are already cut to the bone as CEOs took swift action in the aftermath of the crisis to cut employees. So small caps still have more room for improvement.

The iShares Russell 2000 Index ETF (IWM), a benchmark for smaller companies, took a hit today as investors came back from vacation with a ‘take risk off’ mentality. Smaller companies are considered more risky because of their lack of access to super easy borrowing and singular-focused business lines. The credit concerns have eased lately as credit quality has slowly improved from last year, according to banks.

Not to mention, the asset class’s ability to generate sales growth in their smaller niches makes them attractive to the big guys who are trying to move the needle somehow. See the H-P vs. Dell bidding war that finally came to an end for 3-Par, a data storage company with a market value of 2 billion (post-deal), as exhibit A.

CEOs are shying away from the mega-deal and all the shareholder scrutiny that comes with it too in this uncertain environment. The average transaction size for deals has dropped a whopping 66 percent since 2009, according to UBS. Golub is recommending investors concentrate on the technology, industrial and health care sectors for small-cap picks.

The recommendation is a “great thesis," according to Michael Block, chief equities strategist for Phoenix Equities. “Especially since the anticipated business tax credit and/or any real jobs stimulus will really get small caps going."

President Obama will detail the next iteration of his economic recovery plan tomorrow in Cleveland.

Not everyone is going small, however. After all, large caps have giant cash hoards and the ability to deploy dividends as the economy and credit environment trickles along.

In a note last week, Bank of America Merrill Lynch’s small cap strategist, Steven DeSanctis, predicted that “when analysts return from summer vacation, we think we will see a slew of estimates cuts and potential negative preannouncements."

Regardless of your Marco viewpoint, one thing that does favor a look at the smaller portion of the market is the fact that these stocks don’t all trade in unison. In the age of ETFs and large-cap money managers chasing performance, the stocks in the S&P 500 are increasingly correlated to each other.

"I feel like we can get an edge there,” said Karen Finerman, president of hedge fund Metropolitan Capital Advisors and a ‘Fast Money’ trader. “I can know the company better than most. With Microsoft, I’m never going to have an edge.”

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