If the Russell 2000 were a company, would you buy it?
While admittedly a rhetorical question on our part, it also highlights some of the important challenges facing investors right now as we move toward completing a second consecutive year of positive small-cap returns and the near certainty of lower corporate tax rates mixed with mounting concerns over equity valuations throughout the U.S. stock market.
In other words, the signals remain mostly positive - global growth is expanding, GDP at home is trending upwards toward 3%, and we have normalizing, slowly rising interest rates across the developed world.
However, there’s also just enough uncertainty to keep all of us alert. In fact, one of the more interesting stories in 2017 - and dating back to the small-cap bottom on 2/11/16 - is the lack of volatility in the market as a whole. Stocks have advanced with only occasional steps back since early 2016 - and none of these brief downturns for small- or large-cap stocks were declines of greater than 10%.
As enjoyable as it’s all been, share prices simply do not stay aloft forever - which brings us back to the question of how pricey the small-cap index currently looks.
As bottom-up, fundamentally rooted investors in all of our small-cap strategies, we see one flashing red light when we look at the Russell 2000 - more than 34% of its companies have no earnings.
Evaluating the small-cap index the same way that we look at individual companies, by analyzing the intersection of valuation and quality, we think that, when seen as a whole, the Russell 2000 offers insufficient quality (given the dearth of earnings power) and too much leverage to justify its currently elevated valuation, especially in a non-recessionary period.
1Last twelve months, earnings per share, less than or equal to zero.
2The P/E Ratio calculation uses trailing 12-month earnings and excludes companies with zero or negative earnings (23% of index holdings as of 11/30/17). Harmonic Average. This weighted calculation evaluates a portfolio as if it were a single stock and measures it overall. It compares the total market value of the portfolio to the portfolio’s share in the earnings or book value, as the case may be, of its underlying stocks.
3LT Debt to Capital is calculated by dividing a company’s long-term debt by its total capital.
We don’t want to suggest that the small-cap index is hurtling toward an imminent decline, but we do see conditions emerging that will make it harder for loss-making companies to keep advancing.
Rising rates create challenges for unprofitable companies, and high valuations usually cannot keep climbing, even at a reduced pace, without earnings growth as a spur.
And high-quality earners are in relatively short supply within the large and diverse small-cap index.
Looking forward, it seems unlikely to us that the Russell 2000 can match or exceed its 13.8% five-year average annual total return as of 9/30/17; it may have trouble meeting 10.6%, its average rolling monthly five-year number since inception (12/31/78) through 9/30/17.
From our partisan perspective as active small-cap specialists, this means that passive investments in the small-cap market as a whole appear to be courting considerable risk.
However, we also see this heightened risk as potentially good news for active managers, in particular for those focused on companies with earnings and profitability.
Based on our own analyses, our conversations with management teams, and the research that we’ve seen, the earnings picture for select small-caps continues to be positive across a number of industries, including tech, consumer, and industrial areas.
We also see the likelihood of more and more investors focusing on the attributes - as well as the risks - of individual businesses. Indeed, Reuters recently reported that while market volatility remains low, individual company volatility has been on the rise, with earnings news creating the most extreme movements up or down.
Against the backdrop of tax reform likely taking effect early in 2018 and rates continuing to rise (however slowly and fitfully), we anticipate that earnings will remain among the primary drivers of equity returns - which should provide disciplined, active managers the opportunity to shine, as many have so far in 2017.
Our advice remains—“Stay active, friends.”
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: You may obtain a prospectus for any of The Royce Funds on our website at www.roycefunds.com/prospectus or by calling (800) 841-1180. The prospectus includes investment objectives, risks, fees, charges, expenses, and other information that you should read and consider carefully before investing.