Between inflation, rising interest rates and the war in Ukraine, 2022 has not been kind to investors. If you’re looking to make changes to your portfolio as volatility continues to plague markets, an international investment firm says small-cap stocks, especially those with high valuations and little or no profits, may be dragging down your overall returns.
Despite a four-year run in which they outperformed other small-cap stocks, Dimensional says high-priced companies with little profits were the worst-performing segment of the Russell 2000 Index, a prominent small-cap stock index.
“Small companies with high stock prices that lose money or generate little profit may be holding back your small cap portfolio,” John Morrison, senior investment strategist and vice president of Dimensional, wrote in a recent commentary.
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What Is a Small-Cap Stock?
Stocks can be characterized by their market capitalization or market cap – the total value of their outstanding shares. The term “small cap” refers to stocks that have a market capitalization between $300 million and $2 billion. Small-cap stocks are typically more volatile and riskier than large-cap companies, which have market capitalizations of more than $10 billion. Large-cap companies typically grow more slowly than their growth-oriented, small-cap counterparts. Meanwhile, those worth between $2 billion and $10 billion are known as mid-cap companies.
Why Small Caps May Be Sinking Your Portfolio
To study the recent performance of small- and large-cap stocks, Morrison compared the returns of the Russell 1000 and 2000 indexes. While the Russell 1000 Index is made up of the 1,000 largest public companies in the U.S. by market capitalization, the Russell 2000 Index comprises 2,000 small-cap companies.
After posting returns of 25.45% in 2021, the Russell 1000 Index had a -5.64% return in January, according to Dimensional. However, the Russell 2000 Index fared significantly worse during the same time period. In 2021, the index gained 14.82% but posted a -9.63% return in January. That means during the 13-month period that began in January 2021, the small cap index returned just 3.76% while its larger counterpart offered investors a 19.32% return.
Russell 1000 Index returns
- 2021: 26.45%
- January 2022: -5.64%
- Since start of 2021: 19.32%
Russell 2000 Index returns
- 2021: 14.82%
- January 2022: -9.63%
- Since start of 2021: 3.76%
But Morrison found that it’s not all small-cap stocks that lagged in 2021. The top five detractors of the Russell 2000 Index return in 2021 all posted negative profits in 2020 compared to a year earlier. The five companies also traded at price-to-book ratios that placed them in the highest relative price quartile of the market, according to Morrison.
The top five detractors to the Russell 2000 Index in 2021 were:
- Allakos Inc. (-93%)
- Bridgebio Pharma Inc. (-76.5%)
- Invitae Corp. (-63.5%)
- TG Therapeutics Inc. (-63.5%)
- Appian Corp. (-59.8%)
“Looking more broadly, we can see negative 2021 returns across many small caps with low profitability — particularly growth stocks with low profitability,” Morrison wrote. “These stocks were the worst-performing segment by far among small caps in 2021. This follows a four-year streak when these names outperformed other small caps, which led some investors to wonder whether looking to valuation and profitability to make investment decisions was outmoded.”
How to Evaluate a Small-Cap Stock
To evaluate the financial record of a small-cap stock, or any company for that matter, you’ll need to track down the company’s recent financial statement. These public documents, known as Form 10-Q and Form 10-K, must be submitted to the U.S. Securities and Exchange Commission (SEC) quarterly and yearly, respectively. These documents will include revenue figures, liabilities, net income and other metrics to help you determine how profitable the business is.
For investors looking to gain a more granular understanding of a company and its stock, consider the following metrics in your analysis:
- Earnings per share (EPS): EPS represents a company’s earnings for each share of stock issued.
- Price-earnings (P/E) ratio: A stock’s P/E ratio compares the company’s share price to the earnings per share.
- Projected earnings growth (PEG): This number estimates a stock’s one-year earnings growth.
- Dividend yield: If a stock pays dividends to shareholders, the dividend yield reflects how much is paid out per share over a set time period, typically one year.
- Price-sales (P/S) ratio: This represents how a stock’s price compares to its company revenues.
- Return on equity: Return on equity is the result of dividing a company’s net income by its shareholders’ equity.
Bottom Line
Dimensional found that small-cap stocks with high price tags but little to no profits could be dragging down your portfolio’s returns. A prominent large-cap index, the Russell 1000 Index, significantly outperformed it’s small-cap counterpart, the Russell 2000 Index, between the start of 2021 and the end of January 2022. However, it was a quintet of companies with high stock prices and recent histories of falling profits that contributed most to the index’s less robust returns.
Investing Tips
- Even experienced DIY investors can benefit from working with a financial advisor. A fiduciary advisor can evaluate your portfolio and give recommendations to help you meet your financial goals. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors that serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Managing your tax liability is an important but sometimes overlooked part of investing. SmartAsset’s capital gains calculator can help you estimate your tax bill when it comes time to sell investments based on how long you’ve owned them.
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