Growing Divide Among US Small Caps

High-quality and Low-quality Companies Diverging within Small-cap Space

Submitted by EAGLE ASSET MANAGEMENT

There is a growing divide between the haves and have-nots in the U.S. small-cap market, thanks to low interest rates and aggressive monetary stimulus that have made it easier for unprofitable companies to sustain their operations longer than they potentially could have in previous market cycles.

The haves are profitable companies that have experienced steady growth in their profits over time. The have-nots are unprofitable companies that have become even more unprofitable and, along the way, contributed to a decline in the quality of the overall characteristics of the Russell 2000® Index. As a result, this growing bifurcation between high-quality and low-quality companies within the small-cap space effectively masks potential opportunities in some of the more profitable companies in the index.

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Yet despite this growing divide, over the last 10 years active managers have had more success beating the benchmark in small caps relative to other parts of the style box.

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While various investment styles and philosophies have generated outperformance, the Eagle Asset Management Vermont Team has identified certain trends in the Russell 2000 Index that the team believes are exploitable for potential long-term outperformance and risk mitigation.

Since the late 1990s, the number of publicly traded companies has declined from more than 7,000 to roughly 3,500 today because of easier access to private capital and increased regulations for publicly traded companies. This has resulted in much smaller market cap, even micro-cap, names being included in the Russell 2000 Index. By dipping into smaller, more nascent companies, the index provides a growing exposure to oftentimes volatile, unprofitable, and over-leveraged companies. In fact, nearly 48% of the companies in the Russell 2000 Index did not generate positive earnings over the prior 12 months as of June 30, 2020. Said differently, a large portion of the index is nothing more than publicly traded venture capital.

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To be clear, there are wildly successful companies that at one time did not generate a profit, but for every success story there are countless failures. While these smaller, more leveraged stocks can provide outsized returns due to their limited liquidity and expectations for rapid growth, they are at the mercy of capital markets and near-term demand for their products and services since they do not generate a profit and tend to carry higher leverage. These companies have fewer resources to remain solvent during periods of economic stress.

The existential question for these unprofitable stocks is do they provide enough reward to compensate for the additional risk? The data suggest they don’t, and that instead profitable smaller companies have generated outsized returns. In studying what characteristics have driven strong performance historically within smaller companies, Furey Research Partners found strong returns over rolling 10-calendar year periods for a small subset of companies with strong earnings growth, modest debt levels, and high operating efficiency, as measured by returns on equity and invested capital. These companies had market capitalizations of $1 billion to $6 billion and compound annual growth rates of more than 20% over 10-year periods between 12/31/1995 and 12/31/2019, according to Furey Research and FactSet. These “compounders” made up only 8% of smaller-cap companies, but accounted for 45% of the returns over that 10-year period. In other words, the data suggest skilled managers with a bias towards higher-quality companies have historically had success within small caps.

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You might expect that these durable small-cap companies with higher returns would command a premium valuation. What’s surprising is that they actually trade at a meaningful discount to large-cap companies with similar characteristics. For example, companies with return on equity (ROE) between 10% and 25% in the Russell 2000 trade at a 20% discount to similar companies in the Russell 1000® Index. Historically, companies with this criteria have traded with similar valuations across both indices, but only recently has this divergence become so apparent. Arguably the intense crowding into a few select large-cap stocks has contributed to this divergence. Meanwhile, the small-cap space is less covered by analysts and consequently brief periods of dislocation are more common, presenting attractive entry/exit points for opportunistic managers.

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The results of these structural changes in small-cap indices are a low percentage of high performers and many more unprofitable, overleveraged companies. This mix obscures both the potential of the best and the risk of the worst. When economic conditions are robust, these loss-making companies can potentially provide outsized returns. These same businesses, however, are less likely to emerge from periods of market distress as liquidity, solvency, and near-term demand concerns increase. The cohort of smaller durable franchises relies less on outside factors and tends to create value in periods of market turmoil. Moreover, these smaller durable stocks are much cheaper than their large-cap peers at the moment.

These factors point to a strategy that has been historically successful within small caps: Own durable business models that are reasonably priced and can generate profits in both supportive and challenging economic environments.

Eagle Asset Management is an affiliate of Carillon Tower Advisers, an Associate Member member of TEXPERS. The views expressed in this article are those of the authors and not necessarily Eagle Asset Management, Carillon, nor TEXPERS.

Click here for a version of this paper that includes disclosure.