In February, we examined the underperformance of US small cap companies and pinned the lion’s share of blame for that underperformance on stocks with high relative prices (growth stocks) and low, or negative, profits. With the tumultuous first quarter of 2022 behind us, we check in on these stocks to see if it was “just a phase.”
Exhibit 1 revisits the top five detractors to the Russell 2000 Index’s performance in 2021. At the beginning of the year, these companies shared common traits: negative profits over the previous year and price-to-book ratios that placed them in the highest-relative-price quartile of the market. Stocks with high relative prices and low profitability were a poor-performing segment among small caps in 2021, and those expecting a rebound for these names were disappointed: The biggest losers in 2021 flunked the first quarter of 2022 as well.
At the beginning of 2022, all five stocks continued to show low profitability or high relative prices, if not both. Appian, TG Therapeutics Inc., and BridgeBio Pharma Inc. each started 2021 and 2022 in the same market segment: high relative price with low profitability. Negative profitability businesses often prop up their operations by raising equity capital. Invitae Corporation raised $1 billion from Softbank Group and therefore was also classified as a “high asset growth” name. Historically, companies with high asset growth have underperformed their counterparts with more stable balance sheets. The share price of Allakos Inc., the top detractor to the Russell 2000 last year, fell so far in 2021 that it became a value stock in 2022, though its low profitability continues to portend lower expected returns.
Rather than continue to pick on the five horsemen of the small-pocalypse, we can examine the groups of small caps with high relative prices and low profitability, as well as those with high asset growth. Exhibit 2 shows that US small caps with high relative prices and low profitability or high asset growth dragged in the first quarter of 2022, falling by a respective 12% and 20% and compounding losses from 2021. Simultaneously, small stocks with low relative prices (value stocks) and higher profitability showed positive returns amid declines in other small caps.
Exhibit 3 maps the Russell 2000 Index holdings on valuation and profitability characteristics and plots each company with a bubble whose size corresponds to its weight in the index; names that outperformed the index are blue, and those that underperformed are yellow. The map also overlays each quadrant’s performance and shows that a clique of growthy and low profitability names were among those underperforming the Russell 2000 for the quarter, negatively impacting the small cap index’s overall return.
Returns of Russell 2000 Index and small cap market segments
Past performance, including hypothetical performance, is not a guarantee of future results.
Looking broadly across decades of returns in global markets, we observe that small cap growth stocks with low profitability or high asset growth tend to underperform over the long run. And for good reason: from the perspective of valuation theory, paying a lot for a company that earns little profit or requires frequent investment is a good sign of a low discount rate, and therefore a low expected return. By comparison, paying less for more profit indicates a higher discount rate and expected return.
In 2022, the biggest losers from 2021 continued to struggle while value names with higher profits delivered—again. Trying to pick a handful of winners from thousands of small cap companies is a recipe for disappointment. Instead, buying the small cap market minus the riffraff can improve expected returns while still allowing investors to maintain a well-diversified portfolio. Without a crystal ball to name standout performers, history and valuation theory are our best guide. We expect investors who focus on paying less and getting more to thrive.