The stock market has taken a dive over the past month, and the plunge in small-caps has been particularly deep.
The benchmark S&P 500 is down 28% from its Feb. 19 record close, while the Russell 2000 small-cap index has lost 35% over the same period and hasn’t set a new high since August 2018.
Companies in the small-cap category, which typically have a market value of about $2 billion or less, tend to be more sensitive to economic downturns than their larger peers. They missed out on the S&P 500’s march to records throughout 2019 and early 2020 as investors worried about the health of the economic expansion and the impact of the U.S.-China trade war.
And the growing fears of economic disruption caused by the coronavirus pandemic hit when small-caps already showed potential vulnerabilities: The portion of Russell 2000 constituents that don’t make money has been rising, as have debt levels. Light trading in many of the stocks, which can make it harder to buy or sell shares, mark another hurdle for the group.
The ensuing downturn has been severe: Even after posting its biggest two-day gain since November 2008 on Tuesday and Wednesday, the Russell 2000 is on pace for its worst month since October 1987. And since the index peaked for the year on Jan. 16, 96% of the stocks in the group have fallen, with 83% suffering declines of more than 20%, according to Dow Jones Market Data.
“They’ve been eviscerated. I can’t imagine the carnage,” said Bill Costello, senior portfolio manager at Westwood Holdings Group, who co-manages a small-cap fund. “This has just been so fast and so violent.”
As the coronavirus pandemic has spread around the world and reshaped life in the U.S., expectations of a painful economic slowdown have prompted a brutal selloff of risky assets. The S&P 500 and Dow Jones Industrial Average ended their 11-year bull run earlier this month, posting the fastest fall on record from all-time highs to bear-market territory. Banks and investors have warned the worst of the global selloff may still be ahead.
The market rout has been broad and spanned across sectors. Among the small-cap stocks that have taken a big hit over the past month are burger joint Shake Shack Inc., down 40%; apparel company Guess Inc., down 59%; Spirit Airlines Inc., down 64%; and car-rental company Avis Budget Group Inc., down 59%.
One factor that makes small-cap companies sensitive to economic downturns is that many don’t generate earnings to begin with.
The share of companies in the Russell 2000 that aren’t profitable climbed to 29% by the end of November and remained at that level on Feb. 29, according to the most recent data available from BofA Global Research and FactSet. That percentage rose from 19% in August 2012.
The last time a higher share of the companies in the small-cap index were unprofitable was in November 2009, when 31% lost money.
“If in the last 10 years, when we’ve had an economic expansion, you haven’t been able to make money and you’re not profitable, what’s going to happen to you in a downturn?” Mr. Costello said.
Small-cap stocks also entered the market downturn with elevated debt levels. As efforts to contain the pandemic lead to a swift drop in revenue for many companies, those debt obligations could become more difficult to meet, potentially threatening some companies’ ability to stay in business.
At the end of February, the ratio of net debt to earnings before interest, taxes, depreciation and amortization for the Russell 2000, excluding financial companies, was 4.32, according to BofA Global Research and FactSet. That measure was up from 3.43 a year earlier and 2.13 at the end of February 2012.
Large-cap companies generally have more breathing room. For companies in the S&P 500, the net debt-to-earnings ratio was 2.25 at the end of February, up from 1.89 a year earlier and 1.18 at the end of February 2012.
An analysis from Jefferies found that Russell 2000 stocks with higher debt have had a lower return in March than have constituents with lower leverage. The half of stocks with the most leverage declined 35%, including dividends, in the month to date through Friday, while the half with less debt dropped 26%.
“That is a huge gap,” said Steven DeSanctis, small- and midcap strategist at Jefferies. “Any company that has debt on the balance sheet, no one wants to own.”
Alex Ely, chief investment officer of the small- and midcap growth team at Macquarie Investment Management, said he recently bought shares of consumer-staples companies and unloaded shares of home builders.
“We reduced that area because we were worried about the pressure in the bond markets…that would affect mortgages and therefore affect the housing-related companies,” he said.
Another factor that might be contributing to the precipitous fall in small-cap shares: Those stocks are typically more difficult to trade than their large-cap peers.
Goldman Sachs Group Inc. analysts examining liquidity—how readily sellers can find buyers and vice versa—earlier this month found that highly liquid stocks have outperformed stocks with low liquidity. They said they expect that trend to continue until the S&P 500 hits its near-term trough.
The analysts’ group of high-liquidity stocks included the well-known big tech names: Amazon.com Inc., Apple Inc., Microsoft Corp., Facebook Inc. and Alphabet Inc. Its basket of low-liquidity stocks featured smaller companies, such as movie producer Lions Gate Entertainment Corp., oil-and-gas company Antero Resources Corp. and personal-care product company Nu Skin Enterprises Inc.
“There’s not as much interest in a smaller cap company than an Amazon, Google, Apple,” Mr. DeSanctis said. “Those stocks trade pretty freely. In small-cap, when you have times of stress, it’s just much, much wider spreads. You want to get compensated for being one side or the other of that trade.”
Write to Karen Langley at firstname.lastname@example.org
Copyright ©2019 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8