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US Small-Caps Celebrate Miserable Milestone In Never-Ending Selloff
Small-caps outperformed during last week's raucous US equity rally, but that's where the good news stops.
Even with last week's near 8% surge, the Russell 2000 remains almost 30% from its record highs.
If you're looking for bargains, I suppose small-caps are a "good" candidate, but if they're cheap (and I'm not convinced they actually are), there's a reason: Small-caps are especially vulnerable to a higher cost of capital given their steep maturity wall.
This is a special week for the Russe
My one “smallish” cap stock- which faces debt maturity in 2026 (aligns with the above chart), is not unique in that the company took a hit to revenues/earnings for the 3Q (hard to know the source of this – some mix of economic and ongoing supply chain issues) but is unique in that it continues to generate significant enough cashflow (even with depressed results) to allow prepayment of some of the debt between now and 2026. Also, the founder/CEO/COO, who owns 93% of the outstanding shares is a really smart person and he has navigated far more difficult situations during the last 10 years that I have owned this stock.
I believe this “baby has gotten thrown out with the bathwater”…..as it has been beaten down significantly from the ATH with the rest of the small caps- while remaining cash flow positive with a debt load that should be able to refinanced (assuming we don’t have a complete credit meltdown).
I will continue to hold, and lengthen my investment horizon, if necessary, because I still believe my results from holding this over the next 5+ years will pay off. If I were younger, I’d double down- but I am not, and I haven’t decided one way or the other at this time.
Graham and Dodd’s model of valuation based on company fundamentals always had trouble dealing with high growth stocks and market effects. In theory, at least, with a smaller base of market cap, it should be easier for small caps to “take off.” It turns out that the move to unicorn status doesn’t happen as often as the market would like so investors these days seem to be shunning smaller caps until they start making noise. I held the Russell small cap value fund (IWN) for 20 years or so but I have morphed into an income investor and IWN provided only low dividends and little growth so I donated away the embedded gains for the tax benefits and quit on value. I also had a few small caps like WWW that got dumped as well for the same reasons. So my babies are finally out with the bath water, too, and all the stocks I have left are legacy blue chips, all being held on borrowed time.
I spotted a silly irony in all this today. The Dow was created as our first market index to anticipate movement in the NYSE from changes in the value of 30 large “market leaders.” The S & P was created to be a broad reflection of the market based on 500 stocks from multiple venues. The irony is, that the DJIA is barely above break-even this year, while the S & P is up more that double digits. However, the gains in the S & P are almost totally attributable to seven stocks, with the rest averaging essentially flat returns, something that is more easily seen in the behavior of the leaderless Dow.
Small caps outperform at the start of cyclical upturns and underperform in downturns, for many reasons not limited to debt. I speculate, with no evidence, that RUT/RUI may be a leading indicator. In post-pandemic 2020 the equity component of my portfolios was 70%+ small caps (many of which had recently been midcaps). Now it is about 15%.
Similarly, high-debt companies out[under]perform in up[down]turns.
There are many small caps with defensive business models and strong balance sheets. They still suffer from the practical problem that, with little money managed to the RUT, no-one “needs to care” about them.
I will not be surprised if small caps as a class continue underperforming well into 2024.