The attraction to small-cap stocks is simple and seductive, the rationale being that because smaller companies have less exposure to international markets, they are better able to withstand fluctuations in global trade. Small capitalization stocks usually have less revenue coming from abroad and depend less on global logistics and supply chains. Therefore, the logic goes, they are a safe harbor for investors during times of trade uncertainty.
While that thinking has some merit, it ignores some critical facts, not least that small capitalization stocks actually import more as a percentage of sales than large-caps. And when we break open this investment strategy and look closely at the Russell 2000 (the main U.S. small-cap index of about 2,000 stocks), we find two primary reasons for prudence: over-valuation and debt.
As of late 2017, more than one-third of Russell 2000 firms didn’t have any earnings at all; they actually lost money. That number may have improved with the recent changes to U.S. tax law, but it’s still a staggering amount that calls into question the health of a large number of these companies, and by extension, what they are actually worth.
If investing is about comparing the price you’re paying for the value you’re getting, the Russell 2000 is extremely expensive. The current price-to-earnings ratio (P/E) is a whopping 72.96x earnings. If we think of that number as a single business, the market is asking us to pay almost $73 million dollars for a company that generates $1 million a year. To be sure, some businesses historically have grown so fast that they might be worth the super-rich price tag, but we’re talking about 2000 companies and so the law of averages plays out. The following chart compares U.S. small-cap’s cyclically adjusted P/E relative to other U.S. stocks and international stocks. Nothing else even comes close.
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