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Holly LaFon
Holly LaFon
Articles (8839)  | Author's Website |

Royce Funds Commentary: The High Cost of Debt

Co-CIO Francis Gannon explains that, while small-caps as a whole seem to be growing more risky, opportunities still exist for risk-conscious active managers

May 16, 2018 | About:

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 (%)

blog-0518-1

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?

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…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website


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