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Despite a 17% gain in 2023 for the Russell 2000
RUT
index, small-cap and midcap stocks appear to be even cheaper today than they were a year ago.
That would be remarkable, since small-cap and midcap stocks were already quite cheap 12 months ago, according to the website maintained by iShares for the Russell 2000 Index ETF
IWM
].The ETF’s P/E ratio then stood at 13.3, versus 11.8 now.
Appearances can be deceiving, however, for at least two major reasons. The first is that the iShares P/E calculation is based only on those companies that report a profit. Had unprofitable companies been included in the calculation, total earnings of the Russell 2000 companies (the denominator of the P/E ratio) would have been much lower — which in turn would have made its P/E much higher. According to Birinyi Associates, the index’s true P/E — after taking losing companies into account—is 27.1, more than double what iShares is reporting. (For the record, iShares makes it clear that its calculation omits unprofitable companies.)
A 27.1 P/E ratio could still be reasonable if the earnings of small- and midcap stocks were growing at a particularly fast pace. But they’re not. Despite a surprisingly strong economy in 2023, the average company in the index reported lower earnings than in the prior year. According to FactSet data, close to 800 of the Russell 2000 companies lost money over the most recent 12-month period.
“ The portion of earnings pie available to smaller companies is shrinking.”
The second reason to doubt that small-cap and midcap stocks are really as cheap as they may otherwise look is that we’re evolving towards a winner-take-all economy, in which the largest corporations earn most of economy-wide profits. That means that the portion of earnings pie available to smaller companies is shrinking.
Consider research conducted by Kathleen Kahle of the University of Arizona and Rene Stulz of Ohio State. They found a growing share of total income of U.S. publicly-traded corporations being earned by the 100 most-profitable firms. In 1975 that percentage was 48.5%; in 2015 it was 84.2%. That means that the several thousand corporations outside the top 100 are now fighting over little more than the crumbs.
This move towards a “winner take all” economy is not an accident, according to a theory advanced a couple of decades ago by Thomas Noe of Oxford University and Geoffrey Parker of Dartmouth. They argued that so-called “network effects” in an internet economy would increasingly result in industries being dominated by their largest companies.
Over the past five years, the Russell 2000 index has lagged the large-cap dominated S&P 500
SPX
index by 5.9 annualized percentage points. If the economy continues to move ever-closer to the winner-take-all phenomenon extreme, then we should expect the Russell 2000 to continue lagging by similar if not bigger magnitudes — notwithstanding the deceptive headlines reporting attractively low P/E ratios for smaller stocks.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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