As a follow-up to partner Austin Farris’s recent piece on our blog regarding small-cap index performance, we present weird scenes inside the stock market goldmine in July. Using the Russell 2000 as a Proxy, however dubious as we will discuss below, small-caps are up 10.4% QTD as of market close July 18th vs. 2.1% for the S&P 500. Whatup?
The Wall Street Journal entitled this “A Stock-Market Rotation Historic Proportions Is Taking Shape.” Ummm..maybe? We can CNBC you for the moment and discuss issues like: things happen and happen quickly in small-cap investing given limited liquidity; the enormous fun in meme-like short covering; a supposition that there is a Trump Rally which will reignite animal spirits outside the tech world, be good for domestic US businesses, and pull the wraps off M&A/FTC fears; seemingly new signals by the Federal Reserve suggesting fall rate cuts, which conceptually over-benefit smaller or leveraged companies; and/or this is a flash in the pan vs. the first cannon of a real market change.
All giant “who knows,” and any answer from us will of course be hopelessly biased from the enlightened height of our self-interest in smaller-cap investing. But we have some ideas on the “how to play whatever this is” issue.
Our main thought to you is that what passes for indexing in small-cap requires a real stomach for “crappy beta.” To summarize, and enclosed with permission from the big Jim, Grant’s recently summarized the mess:
● In the 12 months ended March 31, the [Russell] index companies generated a 4.7% operating margin, nine percentage points below that which the S&P 500 constituents earned. And if the Russell were a single company, it would carry a speculative-grade credit rating: Net debt of 4.4 times trailing Ebitda compares to 1.5 times for the S&P 500.
● …Russell components set to report a 5.6% decline in earnings in the second quarter; it would be the sixth consecutive period of weakening net income. In contrast, the S&P 500 is projected to deliver a 9.3% rise in earnings per share in the three months ended June, the fastest growth since the first quarter of 2022.
● The bigger the company, the greater its geographical diversification is likely to be. The Russell membership is therefore more exposed to the purely American business cycle than an S&P 500 company would be.
● On a trailing 12-month basis, 42% of the Russell corporate members generated a net loss, up from 30% a decade ago and 20% at the start of the millennium. (This tide of red ink also inflates the index’s aggregate net debt to Ebitda ratio.) For comparison, just 6% of the S&P 500 posted a net loss over the last year.
● The Russell 2000 roster is filled with IPOs and gets depleted by acquisitions and companies graduating to big-cap indexes. The number of new entrants has plummeted. In the decade ended 2023, 1,320 companies came public, less than a third of the 4,362 listings in the 10 years ended 2000.
● Migration across size buckets has decreased to almost half of what it was at the turn of the century. Fewer small-cap stocks than ever manage to become large stocks and instead most of the small-cap universe is just staying small permanently.
● At 1.4 times sales, the Russell 2000 looks like a bargain compared with the S&P 500, priced at 3.0 times sales, though at 29.8 times trailing earnings, the Russell is richer than the S&P, at 24.8 times earnings. The Russell’s elevated p/e multiple is directly attributable to contracted profit margins, and it hardly flatters the Russell companies to note, again, that two-fifths of them make a net loss or that, if the losers were excluded, the index would trade at a more presentable p/e ratio of 18.4 times.
To be fair, more of this is directly focused on the Russell 2000, which is simply a far bigger mess than the S&P 600 smallcap index.
We continue to walk toward this apparent firetrap with some different ideas. The first is to concentrate on a handful of names. We don’t need $10 billion in assets in 750 stocks and worry about the size issues. Though, here is an idea we can execute for someone. Buy the R2000 “just profitable stocks” and short the Russell against it. You can put a lot of money to work and use leverage. This is an idea I stole from someone who literally bought the S&P 500 minus the 20 stocks in forest products and airlines and minted relative performance for 15 years. But yes, we can buy 28 intensely curated stocks in smallcap and accomplish part of the same without you paying active fees for beta exposure.
Another is expressed through our CSC Partners LP. We have deep experience in helping decent, smaller public companies become better businesses with better governance, better capital allocation and better IR – if we are invited. We would argue this is a better way to play small-cap than index hugging a beta with a 43% crap weighting. And part of our mandate is “constructive interference” by taking steps to protect against eternal languishment.
Happy Summer.
