Uncertainty remains high while investor optimism remains low as we enter the last month of 2012. To be sure, there has been and continues to be plenty to worry about both domestically and internationally—many fear that the "fiscal cliff" will push an already sluggish U.S. economy into a recession. Ironically, the market may already be reflecting that fear, given that the Russell 2000 declined 10.01% from its peak on September 14 through its most recent low on November 16. As we approach the end of another volatile year and attempt to peer into the next, we are bemused by today's seemingly endless crosscurrents. Experience teaches that the market rarely does what we expect, and the uncertainty of the last few years has certainly lent credence to that observation.
While we never attempt to predict economic growth or the direction of the market over any time period, we do believe that there are several points about smaller companies that we think should hold true into the New Year, namely that margins still have room to expand, valuation opportunities abound, especially in high-quality smaller companies, and balance sheets remain strong.
From our perspective, there are other points worth making about small-caps in today's uncertain market. First, while popular opinion suggests that margins are likely to flatten or contract, many of our recent conversations with corporate management teams have centered on continued productivity gains, expanding profit margins, and sound capital allocation.
In fact, for many companies the spread between the cost of capital and return on capital has never been wider, which should continue to drive growth and margin expansion. Remarkably, however, small-cap operating margins remain significantly below prior peaks. According to Chip Miller of UBS, "S&P 600 operating margins (ex-Financials) are approximately 18% below last cycle's high."
Small-cap margins in general have been solid, but we surmise they have room to run. Secondly, valuations remain attractive. This is especially true for higher-quality small-caps. Our recent research showed that nearly 17% of the Russell 2000 trades below 10x next year's projected earnings and almost 15% trade below 3x cash as of late November. Not surprisingly, our research also continues to show that the highest quality small-cap companies within the Russell 2000, as measured by return on invested capital, now trade at a significant discount not only to their lower quality siblings, but also to the highest quality large-cap companies.
Finally, balance sheets remain in solid shape. We estimate that cash as a percentage of market cap stands at 14% in late November. At the same time, roughly 40% of the companies in the Russell 2000 now pay a dividend. In addition, many smaller companies are returning capital to stockholders in the form of special dividends prior to the end of 2012 as well as continuing to buy back stock.
Ironically, even as investors were becoming more disillusioned with equities over the past year, smaller companies were allocating their capital more effectively through acquisitions, dividends, and reducing share count through stock repurchases. We continue to believe that prudent capital allocation should be the catalyst to a powerful investment cycle once the fog of uncertainty begins to clear.
In these uncertain times, we continue to follow our discipline and to identify those ideas that we believe will be the beneficiaries of potentially better economic times ahead. As always, we do so with an eye towards risk, a preference for solid balance sheets, and a history of above-average returns.
Interestingly, many of the economic events that the markets feared would pull the U.S. economy into recession have already occurred, including the rapid slowdown in China and the recession in Europe. As the saying goes, bull markets climb a wall of worry—surprisingly , the Russell 2000 gained 12.35% year-to-date, 13.09% over the one-year, 13.85% over the past three years, and 8.71% over the past 10 years through the end of November.