Many investors are jumping into small cap stocks seeking what we call “lottery ticket payoffs.” But we think this is a potential trap that investors need to be wary of. Head of Quantitative Strategies Michael Hunstad, Ph.D., explains.
by Michael Hunstad, Head of Quantitative Strategies, Northern Trust
The economic stoppage caused by the coronavirus crisis hasn't been kind to small cap stock fundamentals, which were already on a slippery slope coming into the year. But, surprisingly, many investors are jumping into small caps, seeking what we call "lottery ticket" payoffs. We think this is a potential trap of which investors need to be wary. Here's why.
Small caps can be an integral part of your equity portfolio, adding both diversification and breadth. However, today, the grim health of many small cap companies should give investors pause. The profit margins of small caps are, on average, negative, in stark contrast to the 8% margins enjoyed by the average large cap firm. Small caps are also highly levered, with more than 40% of their capital structure in debt, compared to about 20% for large caps. The combined impact of declining margins and increasing debt means their profits can only cover about 50% of their interest payments, lows not seen since the global financial crisis.
Although somewhat counterintuitive, price declines in small caps can spur what we call junk rallies. This happens because the marginal investor-- or the investor who is setting the price-- can move from a traditional risk-averse, buy-and-hold type to risk seekers, who are sorting through the rubble and looking for quick wins. This action actually favors low-quality and high-volatility "lottery ticket" like stocks, which have outperformed by double digits in May and June.
We think this rally is superficial and dangerous for prudent investors. Now is the time to focus your small cap exposure on the higher quality end of the spectrum or companies with relatively strong cash flow, lower debt, and stronger profitability. The junk rallies we've seen historically have been severe, but typically short-lived, and the long-term, high-quality stocks have outperformed. Declining fundamentals and the recent price behavior in junkier securities hasn't softened our conviction around small cap stocks, but investors should focus on strategies with high-quality names when fulfilling the small cap allocation in their portfolios.
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