All that glitters: the problem with speculative small caps

In momentum-driven markets, small-cap stocks can display deceptive strength, with the most speculative elements of the Russell 2000 Index driving returns, multiples expansion, and potential volatility. In this article, we consider how more speculative-quality stocks pose outsize risks to investors today and outline the case for maintaining higher-quality small-cap exposures.

Momentum-driven markets get made in the pursuit of yesterday's outperformers. The problem is that investors can swiftly reverse course, and in their efforts to avoid outperformers turned underperformers, they can wipe out the returns they so avidly pursued in the first place. Considering this behavioral seesaw, we think it’s imperative for investors to maintain a focus on quality when investing in small-cap stocks.    

The more speculative names among small caps—which we equate with unprofitable companies that aren’t at an inflection point to deliver sustainable earnings power and/or have overly leveraged balance sheets—have generally outperformed in the first four months of 2019. Indeed, unprofitable companies outperformed in the first quarter in a way that both repeated and intensified the dynamic we saw in the first six months of 2018.

Financial loss-makers constitute about a third of the Russell 2000 Index. In the context of last year’s temporary advance and our current run-up year to date, a relatively narrow selection of software, biotech, and healthcare equipment companies has led the way. What’s different now, though, is that stock prices are rising despite a slowing global economy, lingering questions about the sustainability of U.S. growth, and declining expectations for corporate earnings in 2019. Sooner or later, we think the market will recognize that unprofitable companies are, once again, too risky to pursue to the exclusion of higher-quality names.

From a headline perspective, small-cap valuations, at 24x forward price to earnings (P/E), look somewhat rich. But when we exclude unprofitable companies and focus on higher-quality names, valuations don’t appear so expensive. At roughly 16x to 17x trailing P/E, the nonspeculative core of the small-cap market is comparatively cheap relative to long-term averages. 

To the extent investors register concerns about valuations becoming stretched in today’s market, we think that could propel a rotation into higher-quality companies. Because we can’t know with certainty when this aggregate market shift will occur, we maintain our bias toward quality names regardless of what’s in vogue among small-cap investors.    

In 2019, we don’t expect to see a policy boost on par with last year’s revisions to the tax code—no rocket fuel to help drive the economy or small-cap companies’ earnings power. In other words, there’s likely to be very little standing between investors’ interest in speculative names and investors becoming spooked by declining earnings prospects.

In my experience, I'd say that investors tend to focus on returns and ignore risk until it’s too late. That’s why it always makes sense to focus on quality in your equity portfolio—particularly in small caps, where volatility and drawdowns can be dramatic when the relentless pursuit of growth suddenly loses its appeal.