Editor’s Note: Happy New Year!
Today, I’m sharing Director of Trading Anthony Summers’ article from the December issue of The Oxford Income Letter about where the best value will likely be found in 2025.
I want to hear your thoughts as well – do you have your eye on any particular stocks or sectors this year? Let me know in the comments below.
– James Ogletree, Managing Editor
Buffett is at it again…
The Oracle of Omaha has accumulated his largest cash hoard ever, an astounding $325 billion in cash.
What does he know that most investors don’t?
Unlike many of the fearmongers in the media, I don’t take this as a sign that Buffett is preparing for an imminent crash.
He simply knows two inconvenient truths:
- The ample rewards of stock investing must be balanced against the risks.
- The risk-reward balance is looking less and less attractive.
You see, there’s this thing called the “equity risk premium.” It’s basically the extra return you get for investing in stocks instead of safer investments like Treasury bonds.
When you invest in stocks, you expect to earn more than you would from government bonds because you’re taking on more risk. But today, that extra return is getting squeezed to the smallest levels since the early 2000s.
This is a sign that the stock market is becoming more and more overpriced – particularly large cap stocks, whose valuations have gotten stretched to concerning levels.
The S&P 500 is currently trading at 25 times forward earnings. That’s so far above the historical average that valuations would need to drop by about 3% annually for the next decade just to get back to normal.
Here’s the good news, though: There’s still value to be found for those who are willing to do a little digging.
Small cap stocks, especially those with strong value characteristics, are trading at some of their best valuations relative to large caps in 25 years. While everyone’s been chasing the same handful of megacap tech names, these smaller companies have been steadily building value.
History also shows us that interest rate cuts often lead to significant outperformance for small caps.
Dating back to 1957, small caps have returned an average of about 11% in the first three months of rate-cutting cycles, 19% in the first six months, and nearly 29% in the first year.
The gains after periods of underperformance are even more striking.
When small cap stocks have posted meager returns over a three-year period (as they did from 2021 to now), the bounce back has been remarkable.
According to market data going back to 1982, following these disappointing periods, small caps have gone up over the next three years 99% of the time.
Small caps are also showing stronger projected earnings growth than their large cap counterparts for both this year and next. Combine that with their current valuation discount and the historical data, and you’ve got a compelling opportunity.
But here’s the catch: You can’t just buy any small cap stock.
The key is focusing on quality companies with strong balance sheets, solid cash flows, and durable competitive advantages – in other words, true value stocks. These are where the risk-reward balance makes the most sense right now.
It Pays to Think Small
All the big money managers seem to agree that the broader market looks expensive. BlackRock, Vanguard, Goldman Sachs, and others are all predicting below-average returns for U.S. stocks in the coming years.
Factoring in dividends, buybacks, earnings growth, and valuations, the current consensus is that the S&P 500 will deliver only about 4% annually over the next decade. That’s barely better than what risk-free Treasury bills are offering.
In a market where risk premiums are shrinking and the Oracle of Omaha himself is stockpiling cash, seeking genuine value isn’t just smart – it’s essential. And right now, small cap value stocks might be one of the few places left to find it.
After all, when giants like Buffett are raising cash and valuations are stretched, it pays to look where others aren’t. While everyone else is still scrambling to buy yesterday’s winners, the smart money is quietly positioning itself in small cap value stocks.