Investment Landscape: US Small Caps

• US Small Cap indices currently allocate to overvalued, dilutive firms at elevated levels last observed in the tech bubble.
• This poor allocation of capital corresponds to a noticeable decline in market efficiency between prices and intrinsic value.
• Investors can improve the valuation and wealth creation traits of their small cap allocation by investing in an actively-managed strategy built directly on these principles.

If you’re an advisor considering allocations/managers in the small-cap universe, join us for a 30-minute webinar later this month as we will discuss the themes in this article in more depth. We’ll also cover quantitative themes and trends in the small-cap space, the importance of implementing valuation/wealth creation in portfolio construction and how Applied Finance equity strategies benefit from these principles. 

Webinar: Investment Landscape – US Small Caps
Presenter: John Holt, CFA
Feb. 24 @ 2 PM EST – Click Here to sign up or receive a replay of the discussion

Investment Landscape: US Small Caps

Most investors have likely encountered recent commentary that emphasizes historically high CAPE multiples prescribing allocation away from equities or price multiple value gaps prescribing to “sin a little” in favor of value stocks. While it’s helpful to acknowledge this sentiment across the investment community, Applied Finance has long proven that better investment decisions are made when using a comprehensive valuation framework that incorporates profitability, growth, competition and risk instead of price multiple shortcuts. This also applies to macro commentary and tactical allocation.

Regarding CAPE multiples, it is important to acknowledge rising profits over the previous decade, as well as the low cost of capital environment that not only impacts the discounted value of future cash flows but also the hurdle rate for future investment. When incorporating recent profits, near-term forecasts, and the current discount rate environment into a valuation framework, most broad market US indices are fairly valued. This is an observation, however, that will require continuous monitoring of emerging interest rate and inflation details with an eye on a material rise in real rates.

Regarding price multiple value gaps, it is important to acknowledge the distinction between large and small cap value indices before allocating towards popular style methodologies. The largest cash flow generating firms with significant reinvestment opportunities, while already large components of the S&P 500, become even more concentrated in the S&P 500 Growth index. Most of these stocks are highly profitable, return substantial capital to shareholders, and what many believe are high prices simply reflect our low interest rate environment. In small cap stocks, however, we observe widening intrinsic value upside for several value methodologies compared to their growth peers, as well as in broad market indices that exclude unprofitable firms.

While our research indicates that valuation and wealth creation principles offer timeless insight in portfolio construction, the current characteristics of the small cap investment landscape make them as relevant as ever. In the Russell 2000, we have observed increasing levels of unprofitable firms and shareholder dilution tethered to decreasing market efficiency. Through this lens, we find the most credible parallels between current equity markets and the themes of the tech bubble. Based on these observations, we believe there is strong evidence to abandon small cap passive allocations in favor of more concentrated strategies explicitly tailored to capture valuation and wealth creation themes.

Tactical Valuation in US Small Caps

The Rise of Negative Profits and Shareholder Dilution in US Small Caps

An important theme that Applied Finance reviewed in 2021 focused on the alarming rates of dilution for a material number of firms in the Russell 2000. This theme is worth exploring in more detail, as its implications align tactical guidance in the current marketplace with valuation and wealth creation principles that are useful in forming long-term strategic decisions.

To better understand the current landscape of small cap US stocks, it is helpful to review trends on profitability and dilution across time. Chart 1 highlights the percentage of market cap and constituents in the Russell 2000 with negative operating profits. At the end of June 2021, 28.2% of Russell 2000 firms and 24.5% of overall market cap were represented by firms with negative profits; each higher than levels realized during the peak of the late-90s tech bubble. Negative profit firms underperformed in the second half of 2021, diminishing their market cap contribution to the overall Russell 2000 to 20.6% by year end. In the Russell 1000, for context, negative profit firms currently only represent 4.1% of the overall market cap and 11.6% of total constituents at year end.

Highest Percentage of negative profitability firms in the Russell 2000 Index since Tech Bubble (28%).

Negative profits are often accompanied by reliance on external sources of financing. Chart 2 captures the aggregate financing cash flow activity for positive and negative operating profit firms in the Russell 2000, while Chart 3 presents this data in its cap-weighted yield form. (Financing Yield measures a firm’s financing cash flow divided by enterprise value)

Over 10% of the entire index has increased diluted weighted shares by 25% or more over previous 4 quarters and dilution is accelerating for negative profit firms.

It is noteworthy that absolute levels of dilution accelerated for negative profitability firms as early as 2018 then further increased in March 2021 as 2020 financial statement data became broadly available. Financing Yield for unprofitable firms has hovered around -10% on a cap-weighted basis since 2014, but the overall index weight of unprofitable firms has nearly doubled over the last seven years. Over the previous four quarters, 266 firms in the Russell 2000 have increased weighted diluted shares by more than 25%.

Our final two charts study the intrinsic value characteristics of high and low Financing Yield portfolios. Chart 4 displays that the top 30% of Financing Yield stocks in the Russell 2000 has aggregate intrinsic value upside of 30.7% while the bottom 30% has aggregate upside of -32.6%. In Chart 5, we observe that the current valuation gap between the top 30% and bottom 30% Financing Yield portfolios is 63.3%, exceeding any level achieved during the peak of the tech bubble. It is also noteworthy that the valuation gap began to expand in 2018 when absolute levels of dilution began to increase for unprofitable firms. Over the course of 2021, the top 30% Financing Yield portfolio returned 42.9%, outperforming the bottom 30% portfolio by 37.6% in the Russell 2000, yet this valuation gap further expanded over the course of the last 12 months.

The valuation gap between High/Low Financing Yield companies is bigger than during peak of Tech Bubble. In 2021, the Top 30% Finance Yield firms outperformed the Bottom 30% by 37% while the gap in valuation grew even bigger.

The Rise of Negative Profits and Shareholder Dilution in US Small Caps: Examples & Impact

Dilution & External Financing impacts are best understood through their impact on the overall enterprise value of a firm.

To fully grasp the impact of negative profits and dilution in the small cap arena, we can review several high-profile examples of firms that recently diluted ownership either by issuing additional shares or borrowing incremental debt. These examples represent both value (AMC, SAVE, PLAY) and growth (NVTA, PLUG) style index constituents.

The dilution by AMC Entertainment (AMC) earned notoriety over the past year. AMC initially issued an additional 114M shares in 2020 Q4, which only netted the firm $262M in proceeds at $2.30 per share. This occurred while net income fell to -$4.5B due to theater closures and film production delays in the wake of COVID-related shutdowns. Over the first three quarters of 2021, AMC further increased shares outstanding another 289M shares. Of these, nearly 242M shares were related to secondary offerings netting $1.8B in proceeds at $7.40 per share. AMC’s share price later rose to $27.20 by the end of 2021, pushing its enterprise value to $25.0B compared to only $8.1B at the end of 2018.

Spirit Airlines (SAVE) has seen its price decline significantly from $57.92 at the end of 2018 to $21.85 at the end of 2021, which seems reasonable given the impacts on airlines and travel stocks related to COVID travel restrictions. Once we acknowledge the nearly 60% increase in shares outstanding, $1.0B in incremental debt, and $1.6B in incremental other liabilities, however, we observe that the enterprise value for SAVE is now $1.1B higher than 2018 levels despite the 60% drop in share price. In 2020, SAVE issued nearly 30M new shares at an average price of $12.59 per share, followed by 10M more shares YTD in 2021 at an average price of $35.25 per share.

Early in the pandemic sell-off, Dave & Buster’s (PLAY) issued an additional 17M shares for $183M in net proceeds at less than $11 per share. The stock price of PLAY has since recovered to pre-COVID levels, but their enterprise value is now 60% higher than it was in 2018.

Invitae Corp (NVTA) saw significant appreciation in 2020 despite increasing shares outstanding by nearly 90%. Its enterprise value has since fallen from $9.0B to $5.2B in 2021 despite issuance of 40M additional shares and more than $1B in debt last year. NVTA’s stock price is now below 2019 levels while its enterprise value is 175% higher due to significant dilution.

Plug Power (PLUG) was recently promoted to the Russell 1000 last summer, but it provides a cautionary tale on the impact of dilution over long-term horizons. Since 2018, PLUG has appreciated significantly while the firm has increased shares outstanding by 160%. Despite this recent outperformance pushing PLUG’s market cap to an all-time high, its stock price is still significantly below its levels reached in the early 2000s due to the amount on incremental shares issued over the last twenty years.

While each of these anecdotes provide insight into firm-specific levels of recent dilution, we can attempt to measure if these themes in aggregate have led to elevated market inefficiency. It’s reasonable to conclude that investors have faced many complex themes over the last few years, including historically low interest rates, COVID lockdowns, reopening, accelerated digitization, shifting consumer/work/lifestyle preferences in addition to these dilution concerns. Tethering this to the rise of passive investing and the expansion of thematic concentrated ETFs, it is reasonable to assume that the elevated levels of active share between intrinsic value and cap-weighted indices provide a useful barometer for market inefficiency in small caps and the degree in which price discovery may be muted. In Chart 6, we observe that recent levels of active share are significantly higher than any level observed since early 2000, and this began to increase as early as 2018 alongside the expansion of unprofitable firms.

Active Share between intrinsic value and market cap weighted indices in Russell 2000 are at highest levels since 2000.

Strategic & Tactical Allocation in US Small Caps

Based on these observations, small cap allocations may benefit from avoiding stocks with negative operating profits and dilution. S&P indices explicitly exclude non-earners, which improves aggregate upside to 8.0% compared to -4.6% for the Russell 2000. Table 1 highlights that intrinsic value upside further improves in small cap value indices, but higher upside is offset by lower Economic Margins or dilutive traits. As we noted earlier, broad value indices are also impacted by negative profit firms. (25.9% of the Russell 2000 Growth index is comprised of negative profit firms vs. 12.3% of the Russell 2000 Value index)

By specifically targeting valuation and wealth creation themes, Applied Finance’s US Small/Mid Cap strategy only holds 130 stocks, but these positions have aggregate intrinsic value upside of 87.9%, 2.3% Financing Yield, and 9.1% forecasted Economic Margins, which vastly exceed broad small cap index alternatives. While there is merit to portfolio construction rooted in valuation and wealth creation principles across all market regimes (based on our Valuation Beta asset pricing research), the elevated levels of negative profit firms, dilution, and market inefficiency suggest that concentrated strategies built on these principles can distance investors from the poor capital allocation currently embedded in small cap and small cap value indices.

We can more broadly isolate the benefit of a valuation discipline in Chart 7 by comparing the aggregate upside of alternative approaches to position sizing based on market value, book value, and intrinsic value across all constituents in the Russell 2000. The cap-weight index has -4.5% upside, while upside improves to 42.2% when intrinsic value determines index weights. Forming position weights on book value mildly improves intrinsic value upside to 11.7%, similar to the upside calculated on the Russell 2000 Value index weights displayed in Table 1.

There is an incredible opportunity in the small-cap space for investors focused on Valuation & Wealth Creation principles.

Next, we can incorporate wealth creation principles by forming High and Low Valuation Stewardship portfolios on the Excess Intrinsic Value and Financing Yield factors motivated in our asset pricing study. In Chart 8, we note that the valuation gap between each basket is 76.4%, which is a level last observed in the tech bubble.

We can further explore the historical performance and the current valuation gap on the High and Low Valuation Stewardship portfolios by sector in Table 2. This helps affirm the strategic and tactical benefits of valuation and wealth creation principles, as these concepts have performed incredibly well within each sector over the last 23 years and also provide significant valuation gap levels today. The current valuation disparity in Health & Technology is especially noteworthy, as more than 40% of non-earners by market cap are included in these sectors.

Webinar: Investment Landscape – US Small Caps
Presenter: John Holt, CFA
Feb. 24 @ 2 PM EST – Click Here to sign up or receive a replay of the discussion

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