In April 2018, I posted TOPSY CURVY: SMALL IS NOT THAT BEAUTIFUL, showing how smaller American companies were struggling with declining margins and high indebtedness.
Smaller caps keep struggling. While the S&P 500 Index is but 2.0% from its September 2018 peak, the S&P 600 Index is still 15.9% lower than its August 2018 peak and the Russell 2000 Index is 12.7% lower, both with sharply declining 200d m.a.. The good breadth in large caps does not extend to the smaller caps, much like the Q1 EPS trends as Ed Yardeni illustrates:
![image_thumb[10]](https://i0.wp.com/www.edgeandodds.com/wp-content/uploads/2019/06/image_thumb10.png?ssl=1 "image_thumb[10]")
![image_thumb[12]](https://i0.wp.com/www.edgeandodds.com/wp-content/uploads/2019/06/image_thumb12.png?ssl=1 "image_thumb[12]")
Actually, small cap dollar profits have not improved in 15 years! Amazing! Everything gained from the tax reform was lost in Q1.
![image_thumb[15]](https://i0.wp.com/www.edgeandodds.com/wp-content/uploads/2019/06/image_thumb15.png?ssl=1 "image_thumb[15]")
![image_thumb[16]](https://i0.wp.com/www.edgeandodds.com/wp-content/uploads/2019/06/image_thumb16.png?ssl=1 "image_thumb[16]")
Now check out these two charts:
![image_thumb[18]](https://i0.wp.com/www.edgeandodds.com/wp-content/uploads/2019/06/image_thumb18.png?ssl=1 "image_thumb[18]")
![image_thumb[20]](https://i0.wp.com/www.edgeandodds.com/wp-content/uploads/2019/06/image_thumb20.png?ssl=1 "image_thumb[20]")
If you think stock buybacks are fooling large cap investors, you should run away from small caps where buybacks have cut shares outstanding by more than half since 2000.
The Fed’s lower for longer interest rate policy has naturally created excesses and misallocation of capital that will become evident during the next recession. Here’s a preview:
But, but, small cap stocks are so cheap! Look at their P/S ratio vs large caps:
Yes, but also consider that S&P 500 companies’ margins are 2.4 times those of S&P 600 companies and rising. On that basis, a large cap dollar of sales should be worth 2.4 times that of a small cap’s.
But, but, look at P/E ratios, small caps are now selling on par with large caps, something we unseen since 2002:
Yes, but why should we pay a premium for no growth other than from share buybacks?
The Russell 2000 Index is at 21.7 times 2019 EPS, a 30% premium over the S&P 500 P/E.
But wait, wait! The 21.7 P/E for the Russell 2000 Index is calculated using profitable companies only. Losses from the 660 unprofitable companies composing the index are simply dismissed for the calculation. This is from the FTSE Russell factsheet of April 30, 2019.
What’s the correct P/E. I have seen many numbers such as 38 (WSJ) or 54 (Birinyi?) but without knowing how it is computed, all I can say is that it is much higher than 21.
Will EPS grow 17% this year as some people say?
Maybe if several of the 660 companies currently losing money suddenly find their way to profitability…but that’s not in the current forecasts:
FYI: only 3 S&P 500 companies currently have negative EPS. S&P 600: 61.
In times like these when the economy is slowing, competition increasing, costs rising and supply chains up in the air, be large, be liquid.
1 thought on “SMALL STILL NOT BEAUTIFUL”
Excellent analysis as always, Denis.
Might the small cap divisor be influenced by stocks not splitting nearly as often, or at all, as they did in the past?
Splits used to be explained as a way to make the stocks more affordable for the average investor, but with ETF’s and passive investing, it’s likely less of an issue these days.
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