Small Cap Stocks Have Been Lifted by Unprofitable Companies. Can They Continue Climbing?

The froth in U.S. stock markets can be seen in small companies too.

The Russell 2000 index has outperformed the S&P 500 since this year’s April troughs, hitting records this week thanks to bets that interest-rate cuts can keep them climbing. Those hopes have fueled optimism that small-caps—generally, those with market capitalizations between $250 million and $2 billion—will continue to climb.

But under the hood of the index, some investors see reasons for concern. Unprofitable companies in the Russell 2000 had surged about 19% this year through Oct. 21, more than double the 9% gain for profitable firms, according to Oren Shiran, portfolio manager of the Lazard US Systematic Small Cap Equity ETF (SYZ). And the S&P 600—the small-cap index that requires positive earnings—is up about 2% for the year as of Thursday’s close, lower than rates offered by low-risk CDs.

Investor enthusiasm over the prospect of lower interest rates, which tend to benefit small companies, may have driven the speculative rally, Shiran said in an interview with Investopedia. (Federal Reserve Chair Jerome Powell tempered rate-cut expectations this week after the Fed trimmed its key rate for the second time in as many months, but market participants still expect more cuts are coming.)

In spite of the speculative lift, fund managers continue to make a case for small-cap stocks, because they are expected to show stronger earnings growth following two years of relatively little movement in profits.

Also, small-cap valuations remained relatively attractive at the end of the third quarter even after its run-up from April lows. That shows in two ways—the Russell 2000’s total market capitalization as a percentage of the total market index Russell 3000 is at 4.4%, substantially lower than the historical average of 7.6% since late 1984, according to Royce Investment Partners. And small-cap valuations compared to large-caps as measured by enterprise value to earnings before interest and taxes, after stripping out companies with profit losses, are near 25-year lows, the firm said. Meanwhile, the Russell 2000’s estimated 2025 earnings is expected to rise over 25%, more than double the Russell 1000’s 10%.

A strong U.S. economy is generally seen as particularly helpful to smaller companies, which tend to have less international business. There’s uncertainty in that “recent jobs numbers have been underwhelming, consumer confidence is still wobbly and manufacturing data has been sluggish,” Francis Gannon, Royce’s co-chief investment officer wrote in a quarterly note earlier this month. “However, consumers continue to spend, the economy is growing, and access to capital has widened with the reduction in rates.”

The concerns about small-caps echo those leveled at stocks generally, with indexes at records, but unlike their large counterparts, they haven’t had their time in the spotlight for years. If asset prices and historical returns revert to their long-term averages, per mean reversion theory, then small-cap stocks should continue running.