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Low interest rates are good for stocks. Are they good for the stock market?
That seems like an odd distinction, but it is one that could weigh on American investors’ future returns. There aren’t nearly as many companies to buy, and the ones that remain just aren’t what they used to be.
Most investors are pleased with their portfolios these days, whether they own some of the popular names like Nvidia, Microsoft and Apple that have been powering the market or mutual funds lifted heavenward by the same group of companies. It is at times of top-heaviness like these that contrarians who want to stay invested have pivoted to the market’s forgotten corner: small stocks.
For example, the leading large-company index, the S&P 500, beat the most popular small-company equivalent, the Russell 2000, by 93 percentage points during the 1994-99 tech boom. Like today, a handful of large companies made up a disconcerting share of those gains. Then through 2014 the small-cap index beat the S&P by 114 percentage points.
But the latest bull market has damaged that escape ramp. Look no further than one of the broadest measures of U.S. equities: The FT Wilshire 5000 Index had far more stocks to choose from than it could fit a quarter-century ago. Recently it was down to 3,381 members, which doesn’t make for quite as catchy a name.
It seems like that shouldn’t be happening. Americans have rarely been as excited about stocks as they are today and have never had as many ways to slice and dice the market cheaply, but they are ordering from a shrinking menu: There are now close to three times as many stock funds available to them as listed American companies. Even though an unprecedented 70% of the world’s stock-market value is American, including all 10 of the most valuable companies, fewer than 10% of listed companies in the world were in 2022, according to the World Bank—less than half the proportion of the late 1990s.
How can both be true? The explanation is that a long period of low interest rates and the rise of index funds made smaller U.S. companies attractive acquisition opportunities.
“A lot of these profitable companies that were more like a bond that we love were bought,” says Eric Cinnamond, co-founder of Palm Valley Capital Management. The small-cap and value-investing veteran says it was a combination of other companies and private-equity investors using cheap debt that snapped up hundreds of attractive corporations. That presents a problem for Cinnamond and anyone else focused on earning a high return on smaller companies: extremely slim pickings.
“The ones that remain have profit margins way below the historical norm.”
If you simply sort the market into large versus small and look at published valuation measures, then that problem isn’t obvious. For example, FTSE Russell divides the U.S. market into the largest 1,000 and the next 2,000 stocks. A leading exchange-traded fund tracking the latter group, the iShares Russell 2000 ETF, supposedly has a trailing price-to-earnings ratio below 13 times, whereas the most popular one tracking large stocks, the SPDR S&P 500 ETF, appears far more expensive at about 27 times.
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They are both pricey: Barely half of the companies in the small-company ETF are profitable, and negative numbers aren’t counted in the denominator of that ratio. Even during past deep recessions a higher share of small companies in that index made some profits.
At a time when risk-free Treasury bills yield over 5%, one response could be waiting for stocks to get cheaper. But attempting to time the market usually ends badly for nonprofessionals. A better option for those who prefer cheap index funds might be to choose a healthier benchmark.
For example, a popular index ETF tracking an S&P Dow Jones Indices small-cap index sounds similar to its FTSE Russell counterpart but has beaten it by 300 percentage points over the 24 years both have existed. The difference seems to be that the index provider screens for profitability before adding a stock, so it includes fewer of them. Similarly, a small-cap index maintained by Wilshire recently had a vastly superior average return on equity of 8.63% versus 4.65% for its Russell counterpart. Wilshire published a report in April urging investors to pay attention and “avoid the size trap.”
An even better strategy to bet on a small-cap renaissance might be to choose value stocks or to venture beyond U.S. borders for small-cap opportunities. Similar to the way the stock-performance pendulum has swung too far in the direction of large companies, value investing has been in the doghouse. Foreign, and particularly European small-caps, also appear poised for outperformance, according to a report last week from DataTrek Research. Cinnamond’s small-cap value fund holds few stocks today, but foreign ones are well-represented.
Don’t expect even a well-constructed index to deliver absolute returns similar to past glory days, though. Until the U.S. market is repopulated with good, small companies or more of the current ones turn cheap, stock investors face another hangover from years of low rates.
Write to Spencer Jakab at Spencer.Jakab@wsj.com
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