Over 40% of businesses in the Russell 2000 are losing money. Its price-earnings ratio changes as a result.
Compared to the large-cap S&P 500 SPX, the small-cap Russell 2000 RUT trades at a significant discount. Or it sells for a high price. The source of the data determines everything.
In actuality, little caps now cost a lot more than large caps.
I bring this up to refute the growing argument that smaller stocks are now cheap and should be the focus of bargain seekers because they have dropped so much in recent months.
Even while small-cap stocks have lost far more than the market as a whole and are trading steadily in bear market zone, the industry as a whole is not less expensive than the large-cap sector, even though there are certainly some undervalued companies among the thousands of smaller stocks on Wall Street.
Examine the Russell 2000 index’s price/earnings ratio, which serves as the industry standard for the small and midcap segments of the US market. The Wall Street Journal reports that its P/E is at 32.1 based on trailing 12-month earnings. The typical benchmark for the U.S. large-cap sector, the S&P 500’s 22.1 P/E, is about 50% lower than that.
However, the picture presented by numerous other data sources is very different. For instance, the trailing 12-month P/E for the Russell 2000 is 15.2, which is less than half of what the Wall Street Journal is stating, according to exchange-traded fund provider iShares. The iShares’ number is far lower since, in contrast to the Wall Street Journal, the company does not include losing companies in its calculations, which artificially lowers the index’s P/E.
(iShares footnotes its reported P/E by stating that “negative P/E ratios are excluded from this calculation,” acknowledging that it does not include unprofitable companies in its P/E calculation. Additionally, iShares is not the only company that uses this method to calculate P/E ratios.)
In many cases, it wouldn’t make much difference to ignore businesses that are losing money. However, this is not the case with the Russell 2000. FactSet reports that during the previous 12 months, at least 837 of the companies in that index experienced a loss. That represents over 40% of the components of the index.
This high percentage of unprofitable businesses is in line with a pattern I’ve previously discussed: Only the biggest businesses are receiving an ever-increasing share of corporate profits. Geoffrey Parker of Dartmouth College and Thomas Noe of Oxford University, who recognized this pattern as early as 2000, refer to it as a “Winner-Take-All” economy. Naturally, it will become more crucial to consider unprofitable companies when determining the average P/E of an index if this trend persists.
Pay attention to small-cap stocks with low P/E ratios.
It doesn’t follow that there aren’t any appealing individual small caps just because the small-cap market as a whole isn’t cheap. Finding cheap stocks can be done in a variety of ways. Eliminating businesses that are losing money and those with high price-to-earnings ratios is a smart place to start.
Ken French, a professor at Dartmouth, estimated the long-term performance of a hypothetical portfolio of small-cap firms with low P/E ratios to understand the importance of concentrating on them. It outperformed a portfolio of small-cap high P/E equities by 5.1 annualized percentage points from July 1951 and 2024.
I began by compiling a list of stocks from the Russell 2000 that are now suggested for purchase by any of the investment newsletters that my auditing firm keeps an eye on. I then whittled the list down to the companies that pay dividends and have the lowest forward P/Es (based on FactSet).
The forward P/Es of the 15 equities are shown in order of listing. Among them are First Merchants Corp. (FRME), Hancock Whitney Corp. (HWC), Winnebago Industries Inc. (WGO), American Eagle Outfitters Inc. (AEO), and KB Home (KBH).
