For small caps, index multiples obscure risks

Scott Stutzman, CFA

Portfolio Manager | Research Analyst

7 Aug 2019

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.

The earnings multiple for the Russell 2000 Growth Index may look reasonable – but the headline number does not tell the full story. Index P/E ratios have long provided investors with a quick assessment of stock valuations, but for small-cap stocks, this basic indicator has become increasingly unreliable. The reason: earnings multiples do not 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 currently 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% and is at its highest level in at least 15 years.

US Venture fund chart 2

Biotechnology vs Software - US Venture Fund chart

Source: Janus Henderson Investors, Wilshire Atlas. Russell 2000 Growth Index, data as at 30 June 2019.

Enthusiasm for innovation within the software and biotech industries has driven considerable momentum around all stocks tied to these themes, creating excessive valuations. There is 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 do not 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 is 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 US Food & Drug Administration (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.

For small caps, index multiples obscure risks

Jonathan Coleman, CFA

Scott Stutzman, CFA

A closer look at the index multiple… and what’s actually in the index

Percentage of loss-making stocks in the Russell 2000 Growth Index

Unprofitable biotech and sofware companies are increasing

Reasonably valued small-cap growth stocks still exist

Jonathan Coleman, CFA

Scott Stutzman, CFA

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For small caps, index multiples obscure risks

Jonathan Coleman, CFA

Scott Stutzman, CFA

A closer look at the index multiple… and what’s actually in the index

Percentage of loss-making stocks in the Russell 2000 Growth Index

Unprofitable biotech and sofware companies are increasing

Reasonably valued small-cap growth stocks still exist

Jonathan Coleman, CFA

Scott Stutzman, CFA

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