Some investors are casting a wary eye on a recent rally in small-cap stocks, highlighting the struggles many expect smaller companies to face as the novel coronavirus slows the U.S. economy.
The Russell 2000 - where market capitalizations last year ranged from $150 million to $5 billion - has bounced 20% from its March lows, roughly in line with the S&P 500's 23% gain from its recent trough.
Small-cap stocks are often seen as a barometer of investor sentiment and tend to be among the first to recover in an economic revival. The Russell 2000 index is down 29.7% from its recent February peaks.
Yet some believe betting on a sustained rebound in small caps could be a risky proposition, as the extent of damage from the coronavirus pandemic to the broader economy and smaller firms in particular remains uncertain.
"The good news is, we’ve obviously seen a lot of the downside," said Jill Carey Hall, head of U.S. small- and mid-cap strategy at Bank of America. "That’s not to say there couldn’t be some further downside risk ahead."
Many small-cap stocks were already under a cloud before markets began their decline in February, with more stocks on the Russell 2000 showing higher debt levels and a smaller number reporting quarterly profits, according to Carey Hall.
In aggregate, companies in the index currently have 4.5 times more debt than earnings before interest, tax, depreciation and amortization, compared with a ratio of 3.5 at the end of 2007. And 30% of Russell stocks were not able to report a profit for the last 12 months compared with 18% in 2007, Carey Hall said.
Additionally, 70% of small-cap debt is of the potentially riskier, high-yield variety, compared with 10% for larger-cap companies. Small caps also have a weighted average debt maturity of five years compared with nine years for large caps, meaning that small-cap debts will come due sooner, according to BofA.
"There’s certainly going to be challenges where some small businesses might be at risk of going under," Carey Hall said.
Small-cap stocks have already indicated a recessionary environment. The relative forward price-to-earnings ratio of small cap to large cap recently hit its lowest level in nearly 20 years, well below the levels of the last recession.
Since U.S. lockdowns did not start in many places until around mid-March, they will have the biggest impact only on the last two weeks of the calendar first quarter. But companies like retailers, whose fiscal first quarters go through April, will have seen more prolonged weakness by the time they report. "One of the things you want to see is how stocks respond in April and May to both the awful economic news and the awful earnings," said Steven DeSanctis, small-cap strategist at Jefferies.
DeSanctis is watching whether the Russell can stay above the March 18 close, which was 991.16 - its lowest since February 2016.
Some investors have pointed to signs that appetite for small caps may be growing.
Recent gains in the Russell could be an early indication investors see the U.S. economy bouncing back faster than other economies, said Scott Wren, senior global market strategist at Wells Fargo Investment Institute in St. Louis, Missouri.
But Wren still rates small caps unfavorably compared with large caps, citing issues such as difficulties accessing credit, stalling of buybacks and the economic slowdown due to lockdowns.
Some money managers were also skeptical of the recent gains in the segment.
Phil Blancato, chief executive of Ladenburg Thalmann Asset Management in New York, said smaller companies may take longer to bounce back because consumers are likely to wait for evidence of a medical solution to the pandemic before they resume spending.
"Big corporations can sustain this with their strong balance sheets. Small companies simply can't," Blancato said.
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