Can US Small Caps Ever Work Again?

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Can US Small Caps Ever Work Again?

The old saw that goes “If he didn’t have bad luck, he’d have no luck at all” applies particularly well to the Russell 2000 small cap index.  Consider:

  • YTD the Russell is down 7.0%, making it look more like COVID-19 affected MSCI EAFE (-7.0% YTD) or Emerging Markets (-7.1%) than the S&P 500 (-3.3%).
  • The Russell is now down for the last 12 months on a price basis (-1.5%), versus +11.8% for the S&P, +0.1% for EAFE, but at least beating Emerging Markets (-3.3%) by a hair. 
  • Over the last 2 years the Russell has basically treaded water, up just 1.3% on a price basis, while the S&P 500 is 15.8% higher. 

As for why this is happening, the simple answer is “Valuation”.  The Russell trades for the same forward earnings multiple now (26x) as it did in 2015.  By comparison, the S&P 500 has enjoyed significant multiple expansion over the same period (17x in 2015, 19x now).

Does that make the Russell cheap enough to buy right here?  Let’s do the work and find out…

#1: Since about a third of the Russell 2000 is unprofitable, access to/cost of marginal capital is an important consideration.  As a proxy we look at US high yield corporate bond spreads, so here is the 5-year history for those:

Our take:

  • Changes in spreads across time matter here, and the fact that the cost of high yield debt hasn’t really moved in 2 years neatly explains why the Russell’s returns have been essentially zero over the same span.
  • While the recent uptick in spreads is not that dramatic, history shows it can get worse.

Takeaway: even if the companies of the Russell 2000 are more US-focused (and therefore theoretically less affected by COVID-19), their leverage to marginal cost/availability of capital makes for a tough investment case if capital markets grow more worried about a global recession.

#2: The Russell has notably different sector exposures compared to the S&P 500, making it more “Value” than “Growth” as well as more cyclical:

  • Unlike the S&P, which is 24% Technology (and more like 32% with Amazon, Google and Facebook), the Russell is just 14% Tech …
  • … And it’s not particularly “good” Tech from an investment perspective. Small Cap Tech (S&P 600 sector) is only up 3.9% over the last year versus +30.3% for large cap (S&P 500 sector) Tech.
  • The Russell’s notable overweights to the S&P 500 are Industrials (16% vs. 9%), Financials (15% vs. 12%) and Real Estate/Utilities (13% vs. 6%).
  • Worth noting: despite those dividend-paying overweights, the Russell’s 1.4% payout is still below the S&P 500’s 1.9%.
  • Even though small caps are supposed to be growth stocks, the Russell’s weighting to Growth names is 56% versus 64% for the S&P 500.

Takeaway: the Russell is a good early-cycle play, levered to Industrials and Financials and short of mid/late cycle Tech stocks; the trouble is we’re (at best) in the later stages of the current economic expansion and hoping to skirt the recessionary impact of COVID-19.

#3: The Russell 2000 really is an index, not the S&P 20+480 collection of names:

  • Over a third (34.3%) of the S&P’s value is in 20 names, thanks mostly to the usual suspects (Microsoft 5.0%, Apple 4.6%, Amazon 3.2%, etc.).
  • Conversely, no name in the Russell has more than a 0.5% weight and the top 20 names are just 5.2% of the index.
  • The flip side of this is that the Russell is populated with smaller companies that may not be able to fully compete or address the technological disruption created by the tech heavyweights of the S&P 500. Would you rather own PayPal (in the S&P) or a raft of small banks (such as in the Russell)?

Takeaway: the Russell is likely a better read of Main Street American business than the S&P 500, but its relative lack of killer-app style Tech companies makes that as much a bug as a feature.

Bottom line to all this: unless you see a speedy end to COVID-19 worries, US small caps are not the place to be for long-only investors. There will be a time for this piece of the US stock market to shine, but in the meantime we continue to recommend overweighting large caps.