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[转贴] Unseen Dangers in Small-Cap Stock Rally

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发表于 2018-1-21 03:03 PM | 显示全部楼层 |阅读模式


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Small-company stocks have begun the year with the wind at their backs. They’ve risen 3.4% through the first half of January, a strong kickoff by historical standards. There is some evidence that a strong January points toward a strong year.

Many people are making the bull case for small-caps as an asset class, and it’s an appealing one. The U.S. economy is still getting better, and earnings are rising. The new administration has been mostly friendly to business. Away from the soap opera, it has been cutting back federal regulations, and the new corporate tax cut should boost net earnings.

Meanwhile, the bull market for small-caps is less than two years old. The Russell 2000 tumbled 25% between July 2015 and February 2016. Such bear markets are usually followed by longer uptrends in stocks.

Jeff James, manager of the Driehaus Small Cap Growth Fund (ticker: DVSMX), expects many companies to raise their guidance when they report earnings in the next few weeks. That should keep the party going for a while longer.

But there are more risks out there than many investors realize. Small-caps today are expensive by historical standards. Worse, they are almost certainly more expensive than the headline numbers suggest. They are also, as a group, less profitable, more heavily in debt, and more exposed to the threat of rising interest rates than many investors may realize.

None of this may pose an immediate danger to a segment of the stock market that is enjoying momentum. As the old Wall Street saw has it, don’t fight the tape. But these factors pose longer-term concerns.

CONSIDER VALUATIONS. Wall Street values the Russell 2000 index at about 28 times forecast earnings. But this number, while still high, flatters to deceive. That multiple excludes all the companies that are losing money. Yes, that’s true for most stock indexes. But among small-caps it really matters. Some 34% of the companies in the Russell 2000 are currently losing money.

Factor those back in and, according to a Barron’s analysis and FactSet Research data, the Russell 2000 trades at 56 times 2017 earnings, and 36 times those forecast for the next 12 months. Those are lofty multiples. You need a lot of things to go right to justify owning or buying stocks trading at 56 times trailing earnings.

Unseen Dangers in Small-Cap Stock Rally
Yes, there are arguments for excluding these companies from the valuation multiples. FTSE Russell says they tend to distort the overall picture. Other analysts note that many loss-makers in the index are high-risk, long-term ventures such as biotechnology companies—lottery-ticket stocks for which current earnings aren’t particularly relevant. They will either cure cancer or go bust, and it’ll take about 10 years to find out which. What’s the right price/earnings ratio for that?

Yet this is still a little misleading. If investors in the index profit from earnings, they must also shoulder the losses.

Among the consequences: We don’t really know how big the overall effect of the corporate tax cut will be. Companies that are losing money will receive little benefit, for the obvious reason that they pay no income tax anyway.

Possibly more ominous is the matter of debt. According to Bloomberg data, small-caps in the Russell 2000 have more than doubled their overall net debts in the past five years. Everyone knows why: low interest rates, low inflation, and the Federal Reserve have allowed them to leverage themselves up cheaply.

Many companies have borrowed to expand, take over competitors, or simply buy back their own shares. It’s done wonders for their stock prices. But it hasn’t always helped their underlying business. Average returns on assets for small-cap stocks have tumbled by a third since 2012, to a little over 2%.

DOES THIS MATTER? Maybe not—if you’ve issued long-term bonds and locked in low interest rates for many years. But what if you haven’t?

Goldman Sachs analyst Jessica Binder Graham found that 42% of the debt owed by companies in the Russell 2000 carries floating interest rates. (That’s compared with just 9% for the big companies in the Standard & Poor’s 500 index). That leaves these small-caps vulnerable to an uptick in inflation, higher short-term rates, or both. Ominously, according to data from S&P and FactSet, in the last 12 months small companies were already spending a third of their earnings before interest and taxes on interest payments. That’s as high a proportion as it was at the worst point in the financial crisis. Indeed.

These things worry Francis Gannon, co-chief investment officer of The Royce Funds, the investment firm which specializes in smaller company stocks. Net debt in the Russell 2000 is higher than it was in 2007, just before the crash, he warns. “There’s a lot of financial leverage that people aren’t thinking about,” he says.

In the short term, the momentum remains with smaller companies. Even the cautious Gannon thinks the economy is better than the consensus realizes. That should, logically, keep the party going, at least for a while. But watch out for interest rates.

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发表于 2018-1-21 11:06 PM | 显示全部楼层
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