How Risky is the Russell 2000?

Small cap stocks

How Risky is the Russell 2000?

If the Russell 2000 index were a company, how attractive would it be to investors? Royce co-CIO Francis Gannon has his doubts.

If the Russell 2000 were a company, would you buy it?

While admittedly a rhetorical question on our part, it highlights some of the important challenges facing investors right now as we move toward a second consecutive year of positive small-cap returns and lower corporate tax rates, mixed with mounting concerns over equity valuations throughout the U.S. stock market.

The signals remain mostly positive—global growth is expanding, GDP at home is trending upwards toward 3%, and we have normalizing, slowly rising interest rates across the developed world.

However, there’s also just enough uncertainty to keep all of us alert. In fact, one of the more interesting stories in 2017—and dating back to the small-cap bottom on 2/11/16—is the lack of volatility in the market as a whole. Stocks have advanced with only occasional steps back since early 2016—and none of these brief downturns for small- or large-cap stocks were declines of greater than 10%.

As enjoyable as it’s all been, share prices simply do not stay aloft forever—which brings us back to the question of how pricey the small-cap index currently looks.

Red light alert

As bottom-up, fundamentally rooted investors in all of our small-cap strategies, we see one flashing red light when we look at the Russell 2000—more than 34% of its companies have no earnings.

Evaluating the small-cap index the same way that we look at individual companies, by analyzing the intersection of valuation and quality, we think that as a whole, the Russell 2000 offers insufficient quality (given the dearth of earnings power) and too much leverage to justify its currently elevated valuation, especially in a non-recessionary period. 

We don’t want to suggest that the small-cap index is hurtling toward an imminent decline, but we do see conditions emerging that will make it harder for loss-making companies to keep advancing. Rising rates create challenges for unprofitable companies, and high valuations usually cannot keep climbing, even at a reduced pace, without earnings growth as a spur. And high-quality earners are in relatively short supply within the large and diverse small-cap index.

Looking forward, it seems unlikely to us that the Russell 2000 can match or exceed its 13.8% five-year average annual total return as of 9/30/17; it may have trouble meeting 10.6%, its average rolling monthly five-year number since inception (12/31/78) through 9/30/17.

From our partisan perspective as active small-cap specialists, this means that passive investments in the small-cap market as a whole appear to be courting considerable risk. 
However, we also see this heightened risk as potentially good news for active managers, in particular for those focused on companies with earnings and profitability.

Keep an close eye on earnings

Based on our own analyses, our conversations with management teams, and the research that we’ve seen, the earnings picture for select small-caps continues to be positive across a number of industries, including tech, consumer, and industrial areas.

We also see the likelihood of more and more investors focusing on the attributes—as well as the risks—of individual businesses. Indeed, Reuters recently reported that while market volatility remains low, individual company volatility has been on the rise, with earnings news creating the most extreme movements up or down.

Against the backdrop of tax reform taking effect early in 2018 and rates continuing to rise (however slowly and fitfully), we anticipate that earnings will remain among the primary drivers of equity returns—which should provide disciplined, active managers the opportunity to shine, as many have so far in 2017. 

Our advice remains—“Stay active, friends.”

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.