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Tactical Valuation: Alarming Dilution Levels in US Small Cap

Over the last few quarters, we have monitored the poor valuation characteristics of dilutive stocks. The top 30% Financing Yield stocks have outperformed their bottom 30% peers by 0.8% in the Russell 1000 and 5.4% in the Russell 2000 in Q3. While this aligns with expectations derived from the massive Financing Yield valuation gap observed at the start of Q3, it is noteworthy that the Russell 2000 valuation gap increased from 59.9% at the end of Q2 to 67.2% by the end of Q3 despite the significant outperformance of high Financing Yield stocks over the course of the quarter.

To reconcile this, we aggregated dilution information for all Russell 1000 and Russell 2000 constituents. In the Russell 1000, dilutive behavior appears mild. Comparing each firm’s most recent quarter to their previous fiscal year filings, common shares outstanding have increased by 0.4% on a market cap weighted basis, while weighted diluted shares have increased by 1.3% and total liabilities have increased by 5.9%. Focusing on the subset of stocks with rising share counts, common share dilution has been 2.3% while weighted dilution has been 4.5%. In aggregate, 3% of all index constituents (31 firms) have increased weighted diluted shares by more than 25%. These dilution levels are similar on a rolling four quarter basis.

Shifting focus to the Russell 2000, we note alarming aggregate dilution characteristics. The recent dilution of AMC shareholders is well documented, but a significant number of other small cap firms have materially diluted existing owners through secondary offerings over the past year. Comparing recent quarterly data to each firm’s previous 10-K, the cap-weighted increase in weighted diluted share count is 11.0% across the entire Russell 2000. Dilution levels are 15.4% for the subset of firms with rising share counts, increasing further to 27.9% on a rolling four quarter basis. 200 firms have increased their weighted diluted shares by at least 25% since the end of 2020, increasing to 266 firms over the previous four quarters.

Recent levels of equity dilution in small cap stocks are concerning. While the Financing Yield metric can help investors simply avoid dilutive firms, a comprehensive valuation framework is required to adequately capture the impact of dilutive behavior on a firm’s intrinsic value per share.

Tactical Valuation: Top / Bottom 30% Factor Portfolios – US Large

Russell 1000 Factor Valuation 9/30/1998 – 9/30/2021

Russell 2000 Factor Valuation 9/30/1998 – 9/30/2021

Size & Style Valuation 9/30/1998 – 9/30/2021

Shifting our tactical valuation focus towards traditional size & style portfolios, we can explore the aggregate intrinsic value characteristics of popular style methodologies and benchmarks.

We can first approximate the Russell style methodology by ranking stocks within the Russell 1000 and Russell 2000 on their book-to-price, sales growth per share, and EPS growth characteristics to divide each index into value and growth partitions, then form cap-weighted portfolios to study intrinsic value relationships over time.

In the Russell 1000, the overall index reflects 2.8% upside (including analyst forecasts through 2024). Large cap value stocks briefly appeared more attractive last year following their sharp sell-off in 2020 Q1, but this valuation gap has since reversed. Large cap growth stocks offer mildly improved upside of 4.8% compared to -0.9% for large cap value stocks.

In the Russell 2000, the overall index reflects aggregate upside of -5.0%, and small/mid cap value stocks offer improved valuation characteristics of 0.6% compared to -8.9% for their growth peers.

Our third chart compares the valuation characteristics of the Russell 1000 and Russell 2000 universes. Since 2003, large cap stocks have offered a favorable valuation gap that narrowed in mid-2020. This valuation gap is currently 7.8% in favor of large cap stocks. Shifting our focus to the S&P 500, we observe that a cap-weighted portfolio of index constituents has also offered higher upside compared to its equal-weighted alternative since 2003. This valuation gap also closed in early 2020 as smaller cap stocks sold-off more sharply than their megacap peers, but the valuation gap is currently 14.7% in favor of cap-weighting.

We can review the current intrinsic value characteristics of an expanded set of style methodologies and popular benchmarks using the investment weights of published ETF holdings as of the end of Q3. Under Morningstar’s style methodology (which expands to 10 factors vs. 3 used by Russell), value is more attractive than growth across each size tier, with a widening valuation gap in smaller arenas. Using S&P’s style methodology (which includes 6 factors), value stocks offer mild upside to their growth peers. Large cap benchmarks (QQQ/IVV) offer more attractive intrinsic value upside compared to more diversified (Russell 1000)/smaller cap (Russell 2000) alternatives, due to the contribution of top 5 market cap stocks which we review here.


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  • Applied Finance, a thought leader in valuation and portfolio construction, is a true “value” investment management company.  Unlike the majority of firms today that focus on low multiples to define “value”, we define value as identifying companies trading below their intrinsic value.  Our Valuation Driven™ approach forms the foundation of our investment decisions...more


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