Knowledge. Shared Blog

July 2019

For Small Caps, Index Multiples Obscure Risks

The price-to-earnings (P/E) ratio for the Russell 2000® Growth Index looks reasonable but may obscure certain risks. Portfolio Managers Jonathan Coleman and Scott Stutzman explain why the earnings multiple can be misleading, where some risks are within small-cap investing and where they still see reasonably valued growth opportunities.

Key Takeaways

  • The earnings multiple for the Russell 2000 Growth Index looks reasonable, but it doesn’t account for companies that have not produced positive earnings.
  • The number of unprofitable small-cap stocks has risen in recent years, making it risky to invest in a passively managed product that replicates a broad, small-cap index.
  • Solid growth opportunities can be found among small caps, but we believe it requires a selective approach.

The earnings multiple for the Russell 2000 Growth Index may look reasonable – but the headline number doesn’t tell the full story. Index P/E ratios have long provided investors a quick assessment of valuations, but for small-cap stocks, this basic indicator has become increasingly unreliable.

The reason: Earnings multiples don’t include those companies that have no earnings. And in the small-cap universe, the number of money-losing businesses has risen dramatically. Their proliferation makes investing in a broad, small-cap index-based product risky, in our view, and underscores the importance of taking a more selective approach.

We believe investors can still find reasonably valued small-cap stocks with solid growth potential. There are just a lot more businesses with questionable profiles to sift through.

A Closer Look at the Index Multiple… and What’s Actually in the Index

At 22x earnings, the P/E ratio for the Russell 2000 Growth Index is on the higher end of historical averages but not unreasonable, in our view. Our concern is the nonearning companies that don’t factor into that metric.

The chart below shows the rise in the number of money-losing companies in the Russell 2000 Growth Index and the decline in companies whose earnings are in the black. The percentage of unprofitable companies in the index is now above 40% (you read that right) and is at its highest level in at least 15 years.

Percent of Loss-Making Stocks in the Russell 2000 Growth Index

Source: Furey Research Partners. As of 06/30/2019.

Many of these unprofitable companies are in the biotech and software industries. The next chart shows how the percentage of money losers in those two industries has grown. In the biotech industry, the portion of unprofitable companies in the Russell 2000 Growth Index is at a 10-year high. In the software industry, that number has declined in recent months but still looks relatively high.

Enthusiasm for innovation within the software and biotech industries has driven considerable momentum around all stocks tied to these themes, creating excessive valuations. There’s no way to assign an earnings multiple to a biotech or software business that is yet to turn a profit, but revenue multiples have expanded considerably.

We don’t try to predict when, but we believe a day of reckoning is due for many of the highly valued, money-losing companies in the index. During broad market sell-offs, it is often the highly valued, momentum-driven stocks that fall hardest as investors recalibrate what type of revenue multiple they are willing to accept for a business.

Economic slowdowns also pose risk for these stocks. Unprofitable companies often sustain their businesses through multiple capital raises. That’s easier to do when the economy is strong, but capital often dries up as it slows down.

Reasonably Valued Small-Cap Growth Stocks Still Exist

We believe the market has taken an undiscerning view toward companies with even a whiff of cyclicality tied to their business. For example, there are many stocks that trade at single-digit multiples, having sold off in recent quarters because of exposure to cyclical end markets or exposure to slower growing sectors.

In many cases, the market fails to give these companies credit for their aftermarket businesses, which can create a steady, recurring revenue stream that makes earnings growth more durable. In addition, we feel that current valuations may be pricing in a recession for many of these companies. Furthermore, while many of these companies could experience slow or even negative revenue growth, many generate strong free cash flows that they can deploy to buffer the potential impact to earnings.

We also see opportunity among small-cap stocks tied to innovative trends such as biotech and software as a service but believe high valuations within those industries require a selective approach. For example, biotech companies with FDA-approved or late-stage pipeline products as well as diversified portfolios as opposed to companies that possess only single-product and/or early-stage drug candidates.

In addition, investors may gain exposure to biotechnology by holding companies providing services that improve drug delivery and development. Such businesses may still benefit from broad industry innovation and the proliferation of new drugs but should be less risky than owning a stock whose performance is tied largely to the binary outcome of a single clinical trial.

In short, we believe the Russell 2000 Growth Index still has opportunities within it – but in our view, investing in a passively managed, index-based product with a large portion of highly valued, unprofitable companies looks risky.

Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
Russell 2000® Growth Index reflects the performance of U.S. small-cap equities with higher price-to-book ratios and higher forecasted growth values.

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