Higher commodity and wage inflation combined with hawkish interest rate expectations may create a challenging environment for U.S. small-cap stocks.
In a prior note (Data Insight: A Turbulent Start to the Year for Global Equities, January 27, 2022), we found that the Russell 2000 has suffered the largest drawdowns to begin the year. As of February 18th, 29% of constituents have experienced a drawdown of at least 50% or more compared to their 52-week high. Furthermore, only 31% of constituents are currently trading above the 200-day moving average.
Smaller companies will have greater challenges managing higher input costs and typically have a less flexible capital structure, which may impact debt servicing and additional funding requests. On the other hand, larger companies have the advantage of scale, pricing power, greater ability to pass on higher costs to consumers, and stronger negotiating power with suppliers to name a few.
Using Refinitiv Datastream, we look at the forward 12-month EBITDA margin for both the Russell 1000 and Russell 2000 indices as shown in Exhibit 1. EBITDA provides an apples-to-apples comparison for small vs. large companies who will have different capital structures.
A picture tells a thousand words, and we can see that large cap companies have traditionally experienced stronger EBITDA margins vs. small caps.
Exhibit 1: Forward 12-month EBITDA Margin Estimate
The current forward 12-month EBITDA margin estimate for the Russell 1000 Index is 19.3% compared to 12.6% for the Russell 2000, a 6.7 percentage point (ppt) difference.
Both the Russell 1000 and 2000 indices have seen a ‘V-shaped’ upward trajectory in EBITDA margins since the trough of 2020. However, the Russell 2000 as only recovered its margin to a pre-pandemic level while the Russell 1000 has reached record-high levels. Again, this can be partially attributed to a combination of greater operating leverage within larger companies and being able to better manage headwinds such as supply chain disruptions.
We also highlight net profit margins for both indices in Exhibit 2 for further insight. Again, we find that the Russell 1000 has a current forward 12-month net profit margin estimate of 12.6% vs. 5.1% for the Russell 2000. We also include the S&P 600 Index, which contains a profitability criterion for inclusion in the index, yielding in a slightly higher margin of 7.2%.
As net profit includes items such as interest expense, it will be an area looked at closely given the potential for multiple Fed rate hikes which will increase borrowing costs on existing or upcoming debt issuances.
Exhibit 2: Forward 12-month Net Profit Margin Estimate
Small businesses job vacancies and price increases
Lower margins combined with the macro headwinds discussed above have resulted in small businesses passing on price increases to the consumer. According to the National Federation of Independent Business (NFIB), 61% of small businesses polled in January responded that they have raised average selling prices (black line) as shown in Exhibit 3. This print marks the highest reading ever since polling began for this question in 1986, underlying the significant cost pressures that loom the industry.
Furthermore, small businesses have struggled to fill open job vacancies since the pandemic began. In the same survey, 47% of small businesses polled in January responded that they have job openings that could not be filled (blue line). This print marks the 4th highest level since 1975 and is well above the long-term 10-year average of 29.7%. U.S. wage growth has increased to record levels in 2021 and continue to post strong year-over-year gains which will need to be factored in the budget for smaller businesses.
Exhibit 3: U.S. Small Business Survey
How are analysts revising estimates?
Using the Aggregates app in Refinitiv Workspace, we can aggregate analyst sentiment for small cap and large cap indices. Exhibit 4 highlights numerous data points for both the Russell 1000/2000 and S&P 500/600 indices.
The Aggregates app allows users to overlay content from multiple content sets including StarMine quantitative analytics. The StarMine Combined Alpha model incorporates all available StarMine alpha models into a single model score, optimized by region and ranked from 1-100.
Large caps in general have a higher StarMine Combined Alpha Model (CAM) score as the Russell 1000 Index has an aggregate CAM score of 59 vs. 49 for the Russell 2000 Index. We note a similar trend in the S&P indices.
Looking at the StarMine Smart Holdings (SH) model, we note that large cap companies are far more likely to ‘pass’ the idea generation screens of institutional investors. The SH model provides an indication of which stocks are becoming desirable in the current environment. The Russell 1000 Index has an aggregate SH score of 68 vs. a score of 49 for the Russell 2000 Index.
Exhibit 4: Aggregates App for Large and Small Cap Indices
Source: Refinitiv Workspace
A benefit of this app is the real-time updates it provides allowing users to quickly track changes in the display window.
Looking at analyst estimates, the forward 12-month EPS estimates have increased by 3.04% for the Russell 1000 Index over the last 90 days in comparison to a 1.23% decrease for the Russell 2000 Index. Top-line estimates have increased 1.67% for the Russell 1000 Index vs. 0.74% for the Russell 2000 Index and EBITDA estimates have increased by 3.00% vs. -0.41% respectively.
We also display FQ1 estimate revisions data which reflects the upcoming quarter and find that EPS estimates for the Russell 2000 Index have declined by 7.22% vs. -0.38% for the Russell 1000 Index over the last 90 days. This reflects greater pessimism amongst analysts in the short-term.
We see similar directional trends in the S&P 500 vs. S&P 600 indices as well, however it appears that analysts have increased FQ1 Revenue, and EBITDA estimates more for the small-cap index vs. large-cap index.
Using Refinitiv Datastream the forward P/E for the Russell 2000 Index is currently 22.9x compared to 19.9x for the Russell 1000 Index. While the Russell 2000 trades typically trades at a premium, the valuation gap has narrowed to a 20-year low and well below the long-term average.
A look at Fund Flows
Now that the backdrop has been laid, we can turn to fund flow to see how the market has reacted. Refinitiv® Lipper® Global Fund Flows are calculated to track the change in assets under management due to sales and redemptions over time.
Using Refinitiv Workspace, we observe that since October 6th, 2021, U.S. large-cap funds have seen inflows of $2.88 billion, while U.S. small-cap funds have seen outflows of $8.74 billion over the same period.
Exhibit 5 highlights weekly fund flows and find that most small-cap outflows occurred since the beginning of the year ($6.33 billion) compared to large-cap outflows of only $470 million over the same period.
Exhibit 5: U.S. Large-Cap vs. Small-Cap Fund Flows
We also break down the small-cap outflows into growth vs. value and find that most outflows that occurred within growth funds. Looking at Exhibit 6, small-cap growth funds saw an outflow of $9.12 billion since October 6th, 2021, while small-cap value funds saw an inflow of $15 million over the same period.
Exhibit 6: U.S. Small-Cap Growth vs. Value Fund Flows
Our Lipper research team provides an update on weekly fund flow data across asset classes. In the February 10th update, they note that within small-cap outflows during the week ending February 9th, Technology ETFs (-$502 million), sector-real estate ETFs (-$402 million), and Healthcare/biotech ETFs (-$385 million) were the top flow detractors under the macro-group (U.S. Weekly FundFlows Insight Report: Equity Funds Post Largest Weekly Inflows of 2022, Attracting $15.9 Billion, February 10th, 2022).
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