Below is a graph of the percentage discount of the Small Cap Sector's Price Earnings (PE) ratio to the JSE Top 40 Index's PE ratio (click to enlarge picture in new window):

Firstly, the average discount of the Small Cap Index's PE to the Top 40's is 6%. The Small Cap sector is currently trading at a premium of 4% to the Top 40.

Does this imply that the index (i.e. small caps sector) is overvalued?

The index PE's are historical in nature as published profits are historical in nature. Hence, these indices PE's are lagging. We've also just seen a recent onslaught of robust and mostly-growing profits during the JSE's 'reporting season'.

So, perhaps, the premium to the Top 40 is more just a forward-looking indicator that the average investor is more bullish about local prospects and, by seeking upside, is trading in a so-called 'risk-on' mode? The recent Future Close Out earlier this week indicated that bulls/bear ratio in the broader market is 55/50, which seems to lend credibility to this 'risk-on' view.

As I said at the end of 2011 (SmallCaps.co.za 2012 Forecasts), 2012 should be an excellent year for equity. As the average small cap has an implicit beta higher than the ALSI, this beta is also arguably best captured in the small (and mid) cap sector(s). When the markets run, small cap often run even further.

Perhaps the Small Cap Index's slight premium rating to the Top 40 is really just reflecting this.

Either way, I remain very optimistic on the small cap sector and reiterate that it is definitely (at least one of) the space(s) you want to be in for the next two to four years.

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