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Aug 14, 2019

Small caps under pressure in current market

Small caps suffering from negative estimate revisions and weaker earnings growth

Although recent market upheavals blur the picture, markets were mostly upbeat in the second quarter of 2019. Small caps have been under pressure however, with the benchmark Russell 2000 index of small companies underperforming the S&P 500, the Dow Jones and Nasdaq.

That said, on a year-to-date basis, the benchmark Russell 2000 index is up nearly 17 percent, though it remains more than 8 percent below the record highs it reached in August 2018.

Margin pressure is weighing on small caps according to Barclays, which now estimates that small-cap companies will post earnings before interest, tax, depreciation and amortization growth of 2 percent this year, down from its estimated 5.5 percent growth earlier this year.

On such analysis, lower margins and less pricing power are preventing small-cap companies from either passing on or weathering the effects of higher trade tariffs to the same degree as large caps.

This in turn, says Barclays, is making investors think twice about small caps – with the result that small caps are left underperforming. This is a big reversal from last year when many investors jumped into small-cap companies in the expectation that they would be insulated from the trade wars because of their focus on domestic markets.

Moreover, the Russell 2000 index is dominated by financial and healthcare stocks – two sectors that face the risk of squeezed margins from what has been a lower interest rate environment and the threat of increased governmental regulation in the US.

In this way, Bank of America Merrill Lynch’s senior US equity, small and mid-cap strategist Jill Carey Hall is highly cautious on small caps: as they have been struggling all year, she says investors should not expect ‘small-cap stocks to break out of an earnings slump’.

She tells IR Magazine: ‘Fundamentals are still weaker down the cap spectrum – small caps have still seen more negative estimate revisions, weaker earnings growth and fewer positive surprises relative to large caps.’

Carey Hall also challenges the narrative that small caps are removed from the trade war picture because of their focus on domestic markets. ‘Even though they’re more domestic, small caps aren’t insulated from trade tensions. Many are suppliers to big multinationals, or can’t as easily shift their supply chains or price through higher costs. The gap between small caps’ foreign exposure and large caps’ foreign exposure has also been narrowing,’ she notes.  

One style Carey Hall expects to outperform is ‘quality’ – especially against a backdrop of rising volatility. ‘But quality has become more scarce within small caps. Right now about one fourth of the Russell 2000 index are non-earners – a level typically only seen outside of or leading into recessions,’ she warns.

The stars among small caps this year are mostly in healthcare and technology, highlighting the different levels and diversity at play in the small-cap arena.

‘Momentum can thrive in a market where you have a wide range of dispersions, and that’s especially true in the small-cap space, where you can have a big difference between the best and worst performers,’ says Jay Gragnani, head of research and client engagement, at Nasdaq Dorsey Wright in a statement.

In another twist in the small-caps narrative is the revelation that UK funds are among the most vulnerable to a market and liquidity shock – especially those that invest in small-cap companies, according to the latest analysis. Research company MSCI analyzed the portfolios of 412 equity funds with more than €1 bn ($1.1 bn) in assets and identified several that would struggle to sell their underlying holdings at a fast enough pace in the event of heavy redemptions without resorting to a fire sale.

This is based on a SEC liquidity assessment, which evaluates an asset as illiquid if it would take more than a week to sell 5 percent of the holding in normal market conditions.