Small-Caps Grossly Underperform Broader Market Amid This Red Flag: 5 Stocks On The Scanner

Small-cap stocks have underperformed their mid- and large-cap counterparts in the broader market recovery seen since late October.

Underwhelming Show: The S&P 600 and the Russell 2,000 Indices, which comprise small-cap stocks, are barely in the green even as the major averages are solidly higher despite the slackness seen in the August-through October period.

The broader market has recovered from the three-month slump and is on the way higher, hoping for a Fed pivot amid a cool-off in inflationary pressure driving the upside. From the October 27 intraday low of 4,103.78, the S&P 500 has run up 10%, and so have the S&P 600 and the Russell 2,000 indices. These two indices have grossly underperformed the S&P 500 Index for the year.

Compared to the 17.6% year-to-date gain for the broader S&P 500 Index, the S&P 600 and Russell 2,000 are up merely 1.18% and 2.07%, respectively.

Chart Courtesy of Benzinga

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What Ails Lesser Knowns: Small-caps may have been hurt by the Federal Reserve’s successive rate hikes implemented since March 2023, a Wall Street Journal report said. It added that these companies raise finances through floating-rate debt and are thereby not insulated against the interest-rate vagaries. From near-zero levels, the Fed funds rate is currently at a 22-year high of 5.25%-5.50%.

The Journal said that about 40% of S&P 600 companies have outstanding floating-rate debt with shorter maturities compared to a more modest 10% of the S&P 500 companies, citing the JPMorgan Equity Macro Research team. It said that small-cap companies are unlikely to benefit from a Fed pause and stand to gain only when the central bank begins cutting rates.

The report highlighted media company The E.W. Scripps Company SSP, theme park operator Six Flags Entertainment Corporation SIX, and sports and outdoor equipment maker Vista Outdoor Inc. VSTO as small-cap names that are stymied by higher interest burden despite the underlying debt declining from the year-ago levels.

Potential Red Flag: Benzinga screened some companies with a high debt-to-equity ratio. Ideal debt-to-equity is traditionally considered to be 2:1. About 331 of small-cap stocks have a long-term debt/equity ratio of over 2:1, and 413 have total debt/equity exceeding the mark.

Some stocks with elevated total equity ratio include:

• NovaGold Resources Inc. NG
• Chicken Soup for the Soul Entertainment, Inc. CSSE
• Gamida Cell Ltd. GMDA
• J.Jill, Inc. JILL
• Hanesbrands Inc. HBI

The above stocks were screened based on their debt-to-equity ratio, and the interest expense was not taken into account.

The WSJ reported that interest expenses at Scripps, Six Flags, and Vista Outdoor rose about 35% and 12% and 20%, respectively, in the third quarter related to the year-ago period.

Erik Knutzen, multiasset class chief investment officer at Neuberger Berman, said he is looking to pare back exposure to some small-caps with high financial and operational leverage, the report said. The analyst cited unprofitability and junk-rated debts as reasons for the same.

The SPDR Portfolio S&P 600 Small Cap ETF SPSM ended Friday’s session at $37.63, up 1.07%, according to Benzinga Pro.

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