US domestic recovery continues to boost small caps - but where is the best value?

Small caps seem to be an immediate turn off to a lot of investors, with fixations on aggregate valuations and volatility meaning the better risk-adjusted returns that can be made within this asset class are often overlooked.

There is reason to have some sympathy with investors: the Russell 2000 index traded on over 30x trailing earnings through mid-2015 and as such, in aggregate terms, valuations can often seem stretched. Simply excluding loss makers from this metric can be instructive, however, and can lower the aggregate valuation by around 20%, bringing small caps more into line with large caps. At the same time, we also find investors are either overly optimistic or pessimistic about the prospects for earnings growth in small caps, which contributes to higher valuation metrics and, in turn, volatility...