by Steven Raineri, Lead Portfolio Manager, Franklin Mutual Series
Small-cap stocks took a rollercoaster ride this summer, but Franklin Mutual Series sees long-term opportunities in quality small-cap value stocks with low debt and good earnings potential.
Small-cap stocks surged in July then dropped in early August before mounting another climb. The rollercoaster ride at least temporarily breathed new life into what has been an unloved asset class. Although the Russell 2000 Index rose over 10% in July on hopes lower inflation will lead to rate cuts, it failed to eclipse recent highs amid the ongoing worries about interest rates, inflation and the possibility of a recession. It also has lagged the large-cap Russell 1000 this year. (See Exhibit 1.)
We believe that enduring success in small-cap investing will come down to active management focused on profitable, higher-quality stocks, which we define as stocks with positive or growing earnings and low leverage, stable business models and good corporate governance, trading at depressed prices relative to their future earnings power.
Exhibit 1: Russell 2000 Index vs. Russell 1000 Index
Look beneath the surface
Smaller companies tend to be more economically sensitive and have more debt, particularly variable rate debt, than larger firms. That makes them more likely to benefit from optimism about the economy and lower interest rates which can potentially reduce their borrowing costs.
On the surface, small-cap stocks have been criticized for their excessive debts, but a deeper look can uncover those with much stronger balance sheets and appealing earnings growth profiles. On average, companies in the Russell 2000 Index have a net debt/EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of 4.4 times as of July 2024, much higher than the 1.6 times for the larger, more established companies in the Russell 1000 Index. (See Exhibit 2.)
Exhibit 2: Russell Indexes: Net Debt to EBITDA
Plenty of growing small-cap stocks with low debt levels exist and we use deep, fundamental research to find them. Grouping stocks in the Russell 2000 Index into quartiles by net debt/EBITDA, for example, allows us to find companies with less debt posting faster compound annual net income growth than more indebted ones.
The least indebted companies in the fourth quartile posted the fastest compound annual growth rate (CAGR) for of 15% from 2004 to 2023, according to data from FactSet. More highly indebted companies in the second quartile saw their net income decline at a 6% CAGR.
Moreover, net income in the third and fourth quartiles, where leverage is the lowest, grew over the past 20 years (See Exhibit 3), while the most indebted companies in the first quartile saw substantial net income volatility.
Exhibit 3: Russell 2000 Net Income Growth by Quartile of Net Debt/EBITDA
Follow the earnings growth
Although approximately 40% of companies in the Russell 2000 do not make money, positive- earning small-cap value stocks members of the Russell 2000 Value Index have actually seen earnings per share expand at a CAGR of 6.1% over the past two decades, just a bit less than the broader Russell 2000’s 6.9% CAGR. (See Exhibit 4.)
Exhibit 4: Earnings Per Share: Russell 2000 Value vs. Russell 2000 Index
Furthermore, profitable small-cap value companies are forecast to deliver earnings growth of about 16% from 2024 into 2025, according to estimates from data provider Bloomberg.1 All this suggests to us that investors can find quality, small-cap value companies that are growing nearly as fast as some growth companies but at much more appealing valuations.
Seek valuation support
Stock valuations remain a crucial variable in an active approach to small-cap investing, as they may not fully reflect the group’s earnings potential. Small-cap equities remain much less expensive than large-cap stocks on both an absolute and relative basis, with the valuation differential near 10-year lows. (See Exhibit 5.)
Exhibit 5: Russell 2000 Value Remains Inexpensive Absolute or Relative
Furthermore, a continued inflection in the yield curve, given the possibility for interest-rate cuts over the remainder of the year, could serve as a catalyst to help further push cheaper, smaller stocks higher. (See Exhibit 6.)
Exhibit 6: Russell 2000 Value Index and US Treasury 10 Year-2 Year Bond Spread
While the asset class may look broadly appealing on a valuation basis, we believe consideration of companies’ leverage and earnings growth profiles is key to finding those that can outperform over time. In our view, deep active management is crucial for a calmer ride in small-cap investing.
Indexes referenced
The Russell 2000 Index is a small-cap US stock market index that makes up the smallest 2,000 stocks in the Russell Index. The Russell 1000 Index is a US stock market index that tracks the highest-ranking 1,000 stocks in the Russell 3000 Index, which represent about 93% of the total market capitalization of that index.
The Russell 2000 Value Index measures the performance of the small-cap value segment of the US equity universe. The Russell 1000 Value Index measures the performance of the large-cap value segment of the US equity universe.
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WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. Active management does not ensure gains or protect against market declines.
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1. As of July 31, 2024. There is no assurance that any estimate, forecast or projection will be realized.
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