Many on the Russell 2000 weren’t generating earnings and had elevated debt — then the virus hit
What started as a sucker punch to the markets has progressed into a veritable beating over the past month. While those with truly diversified and disciplined investing still have reason to hope, it’s hard to discount the dramatic drops across markets and industries — with the smallest companies being particularly hard-hit.
The S&P 500 index went down 28% from its February 19 lose up to yesterday; the Russell 2000 small-cap index lost 35% over the same period, and hasn’t been able to break past the high mark it set in August 2018, reported the Wall Street Journal.
The record surge across stock markets on Tuesday hasn’t helped much as the Russell 2000 is set to have its worst month since October 1987. Since its January 16 peak this year, the index has seen 96% of its constituents fall, including 83% that have declined by more than 20%.
A major weakness of small-cap companies is that they tend to be more vulnerable to economic downturns than their larger peers (though there are limited exceptions). One reason: many aren’t profitable to begin with. Based on data from Bank of America Global Research and FactSet, such companies constituted 29% of the Russell 2000 as of the end of November, and that number hadn’t changed by February 29.
In November 2009, 31% of the Russell 2000 index members lost money; as of August 2012, 19% were unprofitable.
Another factor working against many small-cap firms is their elevated debt levels. With revenue choked off by efforts to contain the pandemic’s spread, they could face challenges in meeting their obligations, increasing the chances that they’ll permanently close their doors.
Citing data from BofA Global Research and FactSet, the Journal said the ratio of net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) for the Russell 2000 — ex financial companies — stood at 4.32. It was 3.43 a year earlier, and 2.13 at the end of February 2012.
In comparison, large-cap firms, as reflected by figures for the S&P 500, had an aggregate net debt-to-earnings ratio of 2.25 at the end of February, rising from 1.89 a year earlier and 1.18 at the end of February 2012.
The low liquidity that typically characterizes small-cap shares could also be contributing to their precipitous fall. In an analysis earlier this month, analysts at Goldman Sachs found that highly liquid stocks have outdone those with little liquidity, and they expected that trend to hold until the next near-term trough in the S&P 500.
“In small-cap, when you have times of stress, it’s just much, much wider spreads,” said Steven DeSanctis, small- and midcap strategist at Jefferies. “You want to get compensated for being one side or the other of that trade.”