Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

As small-cap specialists, we’re often asked what we think the impact of rising interest rates will be on small-cap stocks. Our response is not as simple as saying that it looks likely to be positive or negative.

Looking at the Russell 2000 Index, one may get the idea that small-caps are facing increased risks in the current rising rate environment.

First, 35% of the companies in the small-cap index were non-earners at the end of March. This was one of the index’s highest percentages of non-earning companies since its inception nearly 30 years ago. Equally important, it was also its highest rate ever in non-recessionary periods.

Russell 2000 Now Contains a Historically High Percentage of Loss Making Companies¹

The number of loss-making companies within the Russell 2000 from 12/31/84 through 3/31/18 (%)

¹ Last twelve months, earnings per share, less than or equal to zero.

Source: FactSet.

We think it’s important to remember that these companies reap no benefit from lower corporate taxes and have little backstop against the increasing costs of their own debt—and many small-cap businesses are carrying more leverage of late.

For example, as of 3/31/18, the Russell 2000’s long-term debt to capital rate was 33%, compared to 29% at the end of 2007.

High Percent of Non-Earners + Ample Leverage = Risky Russell?

Risky Russell? Russell 2000 Percent of Non-Earners	Higher Leverage Russell 2000 Average LT Debt to Capital2

² Long-term debt to capital is calculated by dividing a company’s long-term debt by its total capital.

The potential pitfalls for non-earning companies and/or those with higher leverage are exacerbated by two other developments. First, the recent rapid increase in the Libor (the London interbank offered rate) impacts floating-rate corporate debt—and small-caps have significantly more exposure than large-caps.

In fact, a large number of the companies in the Russell 2000 carry floating-rate obligations.

Moreover, of the 1,647 companies in the Russell 2000 that reported EBIT through 3/31/18, 301 are unable to cover their interest expense with earnings—an even greater risk during a period of rising rates. For added context, compare this with the large-cap Russell 1000 Index, where only 43 of 875 companies with EBIT cannot cover their interest expense with earnings for the same period.

This is not an encouraging picture for the small-cap index. However, in spite of (and in certain ways, because of) this admittedly risky state of affairs, we remain cautiously optimistic about the potential for select small-cap companies.

The bulk of our strategies focus on small-cap companies in cyclical industries with growing or steady earnings and low debt (while others emphasize what the managers see as deeply undervalued businesses with catalyst for earnings growth or recovery). Regardless of the specific strategy, all of our managers think of themselves as risk managers—traits that should be useful as the asset class grows more risky.

We think that companies with these profiles—conservatively capitalized businesses with growing or even steady earnings—should be rewarded as rates continue to tick up.

So while we see lower returns for small-caps as a whole, we remain guardedly bullish on the prospects for select small-cap cyclicals—especially those with sufficient international exposure to benefit from the still-expanding global economy.

Stay tuned…

Article by The Royce Funds