In addition to regularly rebalancing client portfolios, we analyze future price-to-earnings ratios (called “forward P/E ratios”) monthly to overweight sectors where earnings appear cheap and underweight those where earnings appear expensive based on historical valuations. This strategy of tilting towards cheaper funds and away from expensive ones is called Dynamic Tilt.

Since 2018, we have been tilting slightly towards Small Cap Value. However, this June 2020, its forward P/E ratio returned very close to its historical average. As a result, we leveled our Small Cap allocation back to our Investment Committee’s static target allocation. This means we are neither significantly tilted towards nor away from Small Cap Value for the first time in a few years.

Market capitalization (how many outstanding shares a company has) is one way of measuring a company’s size. Companies are categorized using their market capitalization into Large, Mid, or Small Cap. As a result, Small Cap represents some of the smallest companies on the stock exchange.

A stock’s valuation is measured on a continuum from “Value” to “Growth.” In broad strokes, Value stocks are cheap and Growth stocks are expensive. Generally speaking, Value stocks outperform Growth stocks. Investing based upon this finding is called “Value Investing.” Value Investing has boasted superior returns for at least half a century, although we have recently been in a season of growth.

Similarly, it has been found that over time, small cap has outperformed large cap even after factoring out measurements of volatility. This makes sense conceptually. It is easier to double the revenue on a small startup company than it is to double the revenue on a large company. In this way, Small Cap’s superior performance depends on a few companies that have such exceptional growth.

Interestingly, the stocks of smaller companies are more thinly traded. This means that even a single investor can move the small cap market as a result of their trading. This is one reason why small-cap stocks are more volatile.

This May 31, 2020, the MSCI USA Small Cap Value Index reported a forward P/E ratio of 22.39, just slightly more than one standard deviation above its historical average.

Because forward price-to-earnings (P/E) is calculated by dividing the current price by the expected future 12-month earnings, a higher P/E ratio either means that the price is higher, the expected earnings are lower, or both.

In the case of Small Cap Value, the price of Vanguard Small-Cap Value Index Fund ETF Shares (VBR) closed at $103.95 on May 29, 2020, this is up 41.78% from its relative bottom of $73.32 earlier on March 23, 2020.

Over the same time period, the MSCI USA Small Cap Value Index forward P/E went from 11.47 at the end of March to 22.39 at the end of May, up 95.20%.

This suggests that both the expected earnings went down and that the price went up. These two movements suggest that Small Cap Value used to be undervalued but is now overvalued.

While this drastic one-month change may suggest tilting away from Small Cap Value, each of our U.S. Stock forward P/E ratios for the month were varying levels above their historical averages. In fact, U.S. Healthcare, Mid Cap Value, and Small Cap Value represented the three most fairly valued sectors in that order.

As a result, we tilted slightly away from U.S. Large Cap and U.S. Technology while leveling off or tilting towards our other U.S. sector allocations.

In the case of Small Cap Value, leveling our allocation meant decreasing our previous month’s allocation by 12.02%. This was a change in our Small Cap Value target from 30.79% of our U.S. asset allocation to 27.09%.

Valuations based on forward P/E ratios are suggestive not predictive. We believe that this dynamic tilt adds another layer of contrarian rebalancing to help boost returns which is why we adjust the tilt of target sector allocations monthly.

As we have seen with Small Cap Value, even though we call this a dynamic tilt, we can spend years tilted towards a sector before valuations suggest that we finally level or tilt away.

As we are still in the midst of COVID-19 quarantines, which makes future valuations even more of a guess than normal. We will have to wait to see what continuing or lifting restrictions actually does to companies, their expected earnings, and their market pricing.

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