It Should Not Be a Surprise That Small Caps Suck

A few weeks ago, we published a piece discussing how much the underperformance of smaller stocks should concern us in the stock market.

We have heard a LOT about this subject in the financial community, and it hasn't died down.

The most interesting part about the piece we published came from the research we did writing it.

We discovered that the ENTIRE market cap and net income of the full Russell 2000 (the primary small capitalization stock index) was LESS than the market cap and net income of just Apple Inc. (NASDAQ: AAPL) by itself!

These 2000 companies have a combined market cap of $2+ trillion, which compares to around $3 trillion for AAPL. They also have roughly $90 billion of net income, while AAPL does almost $100 billion alone!

You may have read the piece and remembered this data, but we find it stunning.

It is also very much NOT a part of the conversation out there.

Many analysts treat the Russell 2000 as if it's as important as the other major indices like the S&P 500 or the NASDAQ Composite. From a numbers perspective, I'm afraid that's not right.

Instead, the Russell 2000 should be treated as simply one big stock.

If AAPL were underperforming the S&P 500 by a large margin, would we be concerned about the stock market as a whole?

It would depend on "why" it was underperforming, but it is just one company.

It makes up about 6.5% of the index, so if the stock is getting killed, it would pull down the index price. Another 499 stocks make up 93.5% of the index, though, to offset it.

From these perspectives, the performance of the Russell 2000 is less concerning.

Let’s look, however, at the fundamentals.

The components of the Russell 2000 do about $2 trillion in revenue. Apple does just (!) $390 billion in revenue. From an economic perspective, the impact of the Russell 2000 on the overall economy is much greater than AAPL.

If the stocks are doing poorly, is it saying something about the economy's health?

Maybe. That $2 trillion of revenue compares to total US GDP of $27 trillion. It is not apples-to-apples, but you could look at it as the Russell 2000, representing 5% to 10% of the economic output in the country.

Interestingly, the relationship of the Russell 2000 companies to total economic output is similar to their size relative to the S&P 500.

If we assume that small-cap stocks are struggling and decide this is saying something pessimistic about the economy, we must recognize that it only says something about a small part of the economy—the 5% to 10% we discussed.

Like our view on the market cap, we think that if 10% of the economy struggles, the other 90% can make up for it.

Why would small caps be struggling economically?

It is logical. They are smaller businesses with less scale, less resource access, and more vulnerability to volatility in input prices and interest rates.

Here is a simple number to think about…the cash holdings of three of the four largest companies in the S&P 500 – AAPL, Microsoft Corporation (NASDAQ: MSFT), and Alphabet Inc. (NASDAQ: GOOG) – have a total of $400 billion of cash on their balance sheets. That would be 20% of the total market cap of the Russell 2000. In CASH…

It is not surprising that these larger companies do better.

With an average market cap of $3 billion in the Russell 2000 (compared to $80 billion for the S&P 5000), it is not surprising that these companies are more vulnerable than their larger cap brethren.

Company performance is a significant driver of stock performance. With the Russell 2000, you have an index full of smaller companies not as well positioned as the large-cap companies that make up the S&P 500.

Accordingly – it shouldn't be a surprise that it underperforms.

We would like to see the small caps performing well, as it would signify the strength in the economy and overall stock market.

The underperformance does not have us worried in the big picture…

Check out Enrique Abeyta’s conversation with Whitney Tilson on the HX Podcast.