When financial news anchors announce the performance of “small-cap stocks,” they almost universally point to the Russell 2000 Index.

To the untrained eye, the Russell 2000 is accepted as the definitive barometer of small-company America. Yet, for disciplined fundamental investors, relying on the Russell 2000 creates a dangerous index illusion.

Beneath its surface lies a glaring flaw: somewhere in the neighborhood of 40% of companies in the Russell 2000 typically generate negative earnings. Around 10% are “zombie” enterprises—businesses that fail to generate enough operating profit to cover even the interest payments on their debt.

In a market where borrowing costs remain elevated, these unprofitable firms drag down index-level returns and severely distort valuation multiples.

This is why, since founding the SmallCap Informer, we have benchmarked our performance against the S&P SmallCap 600 Index rather than the Russell 2000.

Unlike its broader counterpart, the S&P SmallCap 600 enforces a strict financial viability screen: a company must report positive net earnings for its most recent quarter, as well as over the sum of its past four consecutive quarters combined, to be eligible for index inclusion.

By filtering out speculative, loss-making enterprises before a single share is purchased, the S&P 600 isolates the true profit engine of the domestic small-cap universe.

When you apply a profitability filter, the small-cap valuation landscape changes dramatically. Aggregating non-earners in the Russell 2000 distorts its P/E ratio, making small-caps appear confusing or artificially expensive.

On the other hand, when comparing profitable companies of the S&P SmallCap 600 to the large-cap-dominated S&P 500, a valuation discount is clearly evident. The S&P SmallCap 600 currently trades at a forward P/E ratio of approximately 14.1 to 15.8, compared to the S&P 500’s stretched multiple of 22.5 to 26.0. This represents an appealing 28% to 31% valuation discount for high-quality small companies relative to their large-cap peers.

To place this in perspective, global small-caps historically commanded a 10% to 60% P/E valuation premium over large-caps. That “Old Normal” premium was fully justified by smaller companies’ higher long-term revenue growth ceilings, operational agility, and acquisition potential.

Over the past decade, however, passive index inflows—which now account for greater than 54% of U.S. fund assets—mechanically funneled trillions of dollars into mega-cap technology giants, driving relative small-cap forward multiples down to 33-year lows. Historically, whenever the S&P SmallCap 600 forward P/E dropped below 14.0 (as occurred in 1999, 2008, and 2020), it signaled a valuation floor that preceded powerful, multi-year mean-reversion rallies.

So why does this valuation gap persist, and how can investors take advantage of it? We’ll explore that in our next post.

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In this issue, we return to a “behind the scenes” industrial provider that is trading near its 52-week low and presenting a compelling entry point. With more than 70% of revenues driven by high-margin, recurring aftermarket parts, profits look to be well-shielded from economic downturns.

Stay the course!

— DOUG GERLACH 

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the current issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the ~40 high-quality small company stocks currently covered in the newsletter.