May 14, 2019
Audrey Kaplan, Head of Global Equity Strategy
Ken Johnson, CFA, Investment Strategy Analyst
Small-cap Earnings Miss Supports Our Unfavorable View
- In April, we reduced our earnings-per-share (EPS) growth targets from 13% to 9.6% for U.S. small-cap equities to reflect slower earning growth from greater company vulnerability as the economic cycle matures.
- Small-cap valuations and companies who reported negative earnings in 2018 (36% of companies), along with potential margin pressures, may limit further valuation gains.
What it May Mean for Investors
- We prefer U.S. large-cap and mid-cap over small-cap equities and recommend investors consider using active strategies to seek growth opportunities in the small-cap space. We believe earnings forecasts for the Russell 2000—generally considered representative of small capitalization issues in the U.S—have been broadly overestimated.
Small-cap reported and forecast growth is overestimated
As of year-end 2018, bottom-up consensus forecasts1 for U.S. small-cap EPS growth was expected to exceed 30% for both the first quarter (Q1) and the full-year 2019 year-over-year (YoY) growth rates. However, Wells Fargo Investment Institute started the year expecting a more modest increase of 13% YoY growth for full-year 2019. Q1’s current actual reported growth is 4.7%—a significant earnings miss versus consensus expectations for the quarter. The size of this earnings guidance miss in Q1 is much larger relative to other equity asset classes we monitor (see Chart 1).
Based on corporate guidance reports, the consensus has cut 2019 EPS forecasts from 30% to a more achievable 17.4%.2 However, we revised modestly lower to a conservative 9.6% YoY growth rate based on our economic and fundamental forecasts, including our view that margins may compress more in this asset class versus others in 2019.
Both large cap and small cap companies are raising earnings estimates versus year-end 2018. For example, 55% of large-cap companies’ earnings forecast revisions for the next two fiscal years are upgrades, but small-caps revisions are still below neutral (47%), indicating more downgrades occurring than upgrades as Wall Street analysts dissect underwhelming Q1 results (see Chart 1). We believe Q2 forecasts are also too high, and we have expected this trend of underperformance in the small-cap relative large-cap revision momentum to continue. On the bright side, we see more encouraging revision momentum and find several attractive growth areas for longer-term investors. Two Russell 2000 sectors that we prefer for investors include the Financials and Energy sectors, both of which have strong next 12-month forecasts and positive revision momentum.
One-year performance: Small caps have underperformed large caps
Year-to-date, small-caps have outperformed. However, for longer horizons, including the 1-year horizon, the Russell 2000 has lagged. There are several potential contributors indicating why small caps have been trailing over 1-year, 3-year, and 5-year annualized returns:
- Historically, small caps are negatively sensitive to rising interest rates as they have more debt relative to large caps. Following two years with a total of eight rate hikes, we anticipated that small caps would underperform.
- Small caps are negatively sensitive to rising wage costs, which make up a larger portion of cost-of-goods sold versus large caps. Both of these conditions—interest rate hikes and wage increases (which drag on corporate margins)—tend to weigh heavily on small caps later in the economic cycle.
- We believe the main reason small caps are underperforming is the record 36% of Russell 2000 constituents with negative (trailing) earnings in 2018. This high number of “no earnings” companies exceeds the prior peak (35%) hit in September 2009 during the financial crisis. Even during the technology bubble, the peak of companies not making earnings was 30%. While small caps have outperformed in the short term, we believe the current negative earnings, combined with the Q1 earnings miss, will weigh on the asset class in 2019.
Long-term performance: Small caps typically underperform when rates rise
The Russell 2000 Index measures the performance of about 2000 small companies, ranging in market capitalization from $300 million to $2 billion, essentially the smallest 10% of public companies. While small size defines small caps, investors tend to favor these companies due to their potential for rapid growth. Moreover, small caps are typically riskier than large caps; yet, over long periods (e.g. during 1926-2018, small caps returned 11.8%, and large caps returned 10.0%, annually), they may have larger returns than large-cap companies—so investors tend to be paid to take the additional risk. Small caps have tended to have better returns when rates are not rising (Chart 2).
Valuation: Small caps more expensive than large caps
The forward price-to-earnings (P/E) ratio is a fundamental measure used to determine if an investment is valued appropriately based on the forecast for company (or companies’) earnings. In the case of the Russell 2000, many market data providers exclude negative earners for the Russell 2000 Index when calculating the index-level P/E ratio. We believe this is misleading and values small caps more favorably on a P/E ratio of 17.9x. We calculate a forward P/E ratio that includes all negative and small earnings companies. The current forward P/E is 25.1x versus the S&P 500 of 17x.
In the months leading into tax reform, investors were willing to pay an even higher price per unit earnings in the P/E range 28-29x. However, during the December 2018 market trough, P/E broke below 21x. We expect the P/E will remain in a range near the 5-year mean of 24-25x, while we remain at a cross-roads on global growth. Should a U.S.-China trade deal be reached as we anticipate, we could see valuations fall as EPS rises on improving global growth. Alternatively, if global growth decelerates due to increasing trade tensions and rising tariffs, valuations may rise.