(Bloomberg) — U.S. small-cap stocks are as cheap as they’ve been in decades, but with more than half a trillion dollars of debt looming over the next five years, a significant risk signal will be needed from the Federal Reserve to lure investors.
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Small-cap companies in the Russell 2000 Index have a total of $832 billion in debt, of which 75% — or $620 billion — needs to be refinanced through 2029, according to data compiled by Bloomberg. By comparison, companies in the big-cap S&P 500 Index will only have 50% of their obligations due by then.
“No, despite attractive valuations we are not going to buy yet,” said Marija Veitmane, senior multi-asset strategist at State Street Global Markets. “We don’t like small caps because they are much more sensitive to an economic slowdown, have much higher financing costs and are likely to come under further pressure on margins.”
Smaller companies in particular often have a significant amount of floating rate debt, usually in the form of loans, because they are often not large enough to borrow from the bond market. That means their interest costs often increase quickly after the Fed raises rates, while a larger company with fixed-rate bond debt can wait longer before higher rates have a significant impact on their borrowing costs.
Furthermore, the performance of small businesses generally depends on how the economy as a whole performs. With economic conditions changing and uncertainty currently the theme in the markets, Wall Street professionals are skeptical about buying the riskiest stocks – even at seemingly advantageous valuations.
The Russell 2000’s price-to-sales ratio to the S&P 500 is near its lowest since 2003, barring its trough during the Covid pandemic in 2020. But market participants still say the index is priced for perfection and needs a strong rebound will have. economic growth triggers a rally.
“The bigger quality names are more expensive for a reason,” said Guy Miller, chief market strategist at Zurich Insurance Co. “They generally have no problems with financing and are less dependent on interest rate policy.”
Lagging performance
The Russell 2000 is up just 1.6% this year as expectations for rate cuts fell to two from six in January, while the S&P 500 is up 9.5%. But small caps have been lagging big caps for some time, with the S&P 500 more than doubling the Russell 2000’s performance since early 2023.
The small-cap index hasn’t peaked in two and a half years — the longest stretch since the global financial crisis, according to data compiled by Bloomberg. In contrast, the S&P 500 has set and reset records 22 times in 2024.
The problem for small caps now is the direction of rates and the economy, as inflation remains more persistent than expected at the start of the year.
Equity market positioning shows a general lack of conviction in the equity rally that started in late April. Investors have flocked back to the so-called Magnificent Seven technology megacaps, which are considered safer during periods of economic uncertainty, pushing the Bloomberg Magnificent 7 Total Return Index up about 9% over the past three weeks. In contrast, hedge funds have one of the largest net short positions in Russell 2000 futures on record, according to data from Ned Davis Research.
The profits also don’t help small caps. Russell 2000 first-quarter earnings are on track to rise just 0.3%, versus a 4% rise for the S&P 500, BI data show. The remainder of 2024 will likely see an “up and down recovery, potentially leaving the Russell 2000 somewhat volatile,” according to strategists Michael Casper and Gina Martin Adams.
An analysis by Bank of America Corp. shows that even if interest rates were to remain at current levels, operating profits of small caps outside the financial sector are likely to decline by 32% over the next five years, as almost half of their debt is short-term or floating rate.
Money drains
Small caps are increasingly money losers, with about 42% of Russell 2000 companies currently posting negative profitability, up from less than 20% in the mid-1990s, according to data compiled by Bloomberg.
“The quality of companies in Russell is significantly worse than it was 20 years ago,” said Hugh Grieves, fund manager of the Premier Miton US Opportunities fund. “Many more companies have gone public that have never made a profit and probably never will.”
But Grieves is also among the market forecasters who warn against dismissing all small-cap stocks. Another is David Lefkowitz, head of US equities at UBS Global Wealth Management, who sees falling interest rates supporting the group towards the end of the year, and an expected rebound in business activity translating into stronger profits.
“It’s not that small caps are bad,” said Lefkowitz, who made an overweight in the group in December. “It’s just that, relatively speaking, big does better.”
BofA strategist Jill Carey Hall tells clients that it “makes sense to be selective,” as sectors within the energy, basic materials and industrial sectors are attractive given their sensitivity to an improving economy and relatively lower refinancing risks. But investors are proving to be a hard sell.
“The sense we’re getting is that they’re waiting for more confidence in declining inflation and the Fed will be able to start cutting back,” she said.
And for Premier Miton’s Grieves it is not about small caps anyway. It’s about the lack of reasons to avoid the tech giants that have been winners all along.
“What it keeps coming back to is the Magnificent Seven,” he said. “Once they stop outperforming, you will see fund managers become more enthusiastic about small caps.”
—With help from Sujata Rao, Jan-Patrick Barnert, Elena Popina, and Jessica Menton.
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