Industry practice of weeding out unprofitable names to reduce return volatility could mislead investors, critics say
While some benchmarks may suggest that the small-cap space is attractive for investors, a look at the underlying methodology behind some indexes suggests there should be an asterisk next to their performance record.
“By one measure, the Russell 2000 benchmark, whose members have an average market capitalization of about $3.3 billion, recently traded at about 19 times its past year’s earnings, while the large-cap Russell 1000 index traded at 25 times,” the Wall Street Journal reported recently.
By that price-to-earnings measure, small-cap companies might seem like a relative bargain. But as the Journal reported, analysts might omit companies that don’t make a profit in their price-earnings calculations.
Citing an analysis from Jefferies, the news outlet said excluding companies that haven’t made a profit over the past 12 months means disregarding over a third of the market value represented within the small-cap Russell 2000 index. Applying that same method to the large-cap Russell 1000, it said, results in just 8% of the index’s members by market capitalization being removed.
“Metrics that include negative earnings show the Russell 2000 went from trading at 27 times its past 12 months of earnings at the end of March 2020 to trading at 238 times earnings one year later,” the Journal said, referring to data from FTSE Russell. “That multiple fell by nearly half over the following month, and as of July was down to about 70.”
Excluding loss-making companies, the index provider’s data showed, results in a lower and less volatile price-to-earnings multiple for the Russell 2000. From about 14 in March 2020, that number went up to nearly 25 in March 2021 before descending to 19 at the end of July.
Those numbers reflect one reason some analysts defend the practice of leaving out unprofitable companies. Not doing so, they argue, can lead to wild oscillations in the price-to-earnings ratio of the small-cap index, particularly when the economy is in turmoil.
“It makes it a little tougher to figure out what’s the right historical number to compare it to if the ratio is one, very volatile, and two, has also seen a more secular upward trend because of the increasing lack of earning companies” Jill Carey Hall, head of U.S. small- and midcap strategy at Bank of America Global Research, told the Journal.
Still, other analysts maintain that omitting such a significant share of the Russell 2000 means the resulting valuation metric is misleading, especially as investors who own stocks in the index aren’t segregating small-cap companies that way.
“You’re taking out like six, seven hundred companies from your calculation,” said Steven DeSanctis, small- and midcap strategist at Jefferies. “If you took out all the Cs and Ds that I got in high school, I was a solid B-plus student.”
To help prevent potential confusion or bias from one particular index-construction methodology, analysts recommend that investors look at different valuation measures. Looking at price-to-sales or price-to-book ratios, the Journal suggested, means investors are less vulnerable to problems associated with negative numbers.
