Co-CIO Francis Gannon on why too many companies with high leverage and/or no earnings make the Russell 2000 Index look risky.
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I think one of the things investors are missing in looking at the overall market is how risky the Russell 2000 is, going into 2018. I focus on really three aspects of it. One is obviously valuation. We know the Russell 2000 is expensive, by any stretch of the imagination. In fact, if you actually include the nonearning portion of the Russell 2000, which is rarely included when people read about it in the paper, it’s even more expensive than it really looks, at the moment. The other thing is I think people are not focusing on the leverage in the Russell 2000. We’ve seen increased leverage from a financial standpoint within the Russell 2000.
Russell 2000 Average LT Debt to Capital1
1LT Debt to Capital is calculated by dividing a company’s long-term debt by its total capital
In fact, the debt-to-capital ratio at the end 2017 was actually higher than where it was at the end of 2007. People aren’t focusing on financial leverage within many of these businesses right now. And last but not least, I think we live in an environment where the Russell 2000 has had a high portion of the index be non-earning companies.
Russell 2000 % of Non-Earning Companies
So at the end of 2017 slightly over 34% of the Russell 2000 was comprised of non-earning companies. People are thinking that many small-cap companies will benefit from the recently passed tax package. But 34% of the Russell 2000 is comprised of lossmaking companies that truly won’t benefit, from many of the things that have taken place from, a tax standpoint. So I think the Russell 2000 as an index is increasingly more risky than people have really thought about, and it’s a period of time where people have to be increasingly selective in terms of how they approach the small-cap asset class.
Article by Francis Gannon, The Royce Funds