Going back to 1992, the Top 40, Mid Cap and Small Cap sectors' changes in profits have averaged the following annual growth rates (click the image to open a  larger one in a new window):

It is interesting to note how small cap profits have grown on average faster than mid cap profits, which have grown on average faster than Top 40 (i.e. Blue Chip) profits.

But how much would you have to pay in the small cap space for that extra average growth in profits?

Now, we can average the Price Earnings (PE) ratio over this same period as we used above for the same sectors. And, if we have the average annual company growth rate and the average PE ratio (which by definition is annual), well, then we can calculate the PEG ratios (PEG = PE /growth rate; Read about it here). (Click the image to open a larger one in a new window.)

Two things are particularly interesting from the above graph of sectoral PEGs:

1. Top 40 (or Blue Chips) appear efficiently priced for their average growth rate; i.e. PEG = 1.0x.
2. Small caps (as well as mid caps to a lesser extent) are very cheap against their average growth rate.

Is the small cap sector's valuation factoring in an illiquidity discount? Is this sector's valuation depressed by their share price volatility that leads to a higher average Cost of Equity (and this leads to a lower valuation)? Is it basically discounting the growth of small caps due to higher entry and exit costs and higher company specific risk? Is it something else?

The answer to all the above is probably "yes", but the reality is that these risks can be managed by simply investing for the long-term, diversifying and rigorously applying strict fundamentals in stock selection.

If these risk mitigating procedures are used, the average investor can gain exposure to the exceptionally cheap growth rate of the small cap sector while mostly avoiding the pitfalls.

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