Bloomberg News Nir Kaissar has some bad news: The stock market, particularly for smaller companies, is becoming a dumping ground for low-quality, unprofitable companies.
JPMorgan’s CEO Jaime Dimon mentioned that the number of listed companies went down from 7.300 in 1996 to 4,300 today. More companies are staying private.
This is because:
- Regulations have made the cost of being a listed entity more costly.
- With cash from private equity, smaller companies do not need to list. Why go public?
This does not mean that private equity is a winner because private equity may bypass more intense scrutiny which means your private equity fund may own shitty firms.
This phenomenon has made investing in small caps, represented by the Russell 2000 index, challenging.
How does this shape the Russell 2000 index?
The average quality or profitability of companies has declined.
The article measures quality by return on equity [ROE] (net profit divided by book value). The ROE declined from 7.8% to 2.4% currently. This is consistent even if we use return on capital or assets.
We can also gauge quality by the ratio of companies with the lowest ROE to those with the highest ROE. A high ratio means the index is becoming lower in quality.
The chart shows the decline. We now have 6 lower quality companies for each company of the highest quality.
In contrast, the large caps, represented by the S&P 500 index, is expected to post 18% ROE in 2024 compared to 2% for the Russell 2000.
Perhaps it is time to acknowledge that the large caps, in its current form is higher quality, and may justify their higher valuation, relative to the small caps.
So does that mean we should just ignore the small caps?
Nir sorted the companies in the Russell 2000 index by ROE, and there were 235 that had profitability equal to the large-cap. Based on market value, their average ROE is more than double that of the S&P 500 (46%).
If you are selective, you can buy high ROE and low Price-to-earnings small caps.
Nir mentions that you don’t have to do these rankings yourself. Currently, there are funds that screens for lower valuations and higher profitability small caps (as well as large caps).
Such funds would be funds like:
- The Global Targeted Value by Dimensional, which you can buy through Endowus
- The Avantis Global Small Cap Value UCITS ETF (AVWS), accessible through IBKR
- The L&G Russell 2000 US Small Cap Quality UCITS ETF (RTWO), accessible through IBKR
- The SPDR MSCI USA Small Cap Value Weighted UCITS ETF (USSC), accessible through IBKR
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