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Truth versus a Good Story

Never let the truth get in the way of a good story. Small companies, as measured by the Russell 2000 index are trading below 2020 trough levels in relative price terms compared to the S&P500. That has caused some market participants to argue for a long, small cap position in outright or relative terms. Small companies tend to have greater sensitivity (or beta) to the macro cycle. Moreover, small companies also tend to have more domestic earnings as opposed to profits from international operations. In most recessions, small companies tend to underperform the S&P500. A notable exception was the 2008 crisis that arguably had a greater impact on large companies, especially financials (chart 1).

In 2023, the Russell 2000 is barely positive year to date (+0.9%) and has materially lagged the S&P500 (+13.1%). As has been widely discussed, the S&P500 has been driven by a handful of mega-cap technology companies. In contrast, the Russell 2000 has had greater exposure to interest rate sensitive sectors such as regional banks, retail, industrials, and homebuilding that were clearly impacted by the episode earlier this year. The weakness in small companies in relative terms has been entirely consistent with cyclical leading indicators such as the yield curve in the current macro cycle (chart 2).

The big picture question is whether there is “value” in small companies in outright or relative terms? From our perch, the answer is not straightforward at the index level. The Russell 2000 trades at a 50% discount to the S&P500 on a price to book basis. Moreover, the Russell “value” sub-index, clearly trades at a low price to book multiple (chart 3). However, the Russell 2000 has materially weaker earnings or profits, compared to the S&P500. The price to earnings multiple has been consistently higher (earnings weaker) and considerably more cyclical than the S&P500 (chart 4).

The final point to note is that small companies tend to have materially higher balance sheet leverage compared to large companies. Net Debt/EBITDA on the Russell 2000 is 329% higher than for the S&P500 where the index has “de-levered” over the past decade (chart 5). As we often note, valuation is “conditional” of cash flows, profits, and balance sheets. On this basis the index of small companies is inferior to the S&P500. This is also true in other regions. The key point here is not to ignore the small company universe. However, investors should prioritise security selection and active management. The conditional elements of value are always important, but especially in small companies when there has been a large rise in the cost of capital and discrimination is even more important.

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