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Exploring the Benefits of Profitable Small Cap Stocks

By Jason Ronovech
Equities
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Small capitalization, or “small cap,” stocks have generated attractive investment returns over the long term. In fact, dating back to 1926, U.S. small cap stocks have produced annualized total returns of 11.90%, compared to 10.14% for U.S. large cap stocks, and 5.5% for U.S. government bonds. There are several reasons small cap stocks outperform, including higher levels of long-term earnings growth and greater research inefficiencies due to a smaller number of “buy-side” and “sell-side” investors focused in the small cap spectrum of the market due to liquidity. Small cap stocks also outperform over time because they are inherently a riskier asset class. Looking closer at the U.S. small cap asset class, one of the reasons they are riskier and more volatile is the percentage of unprofitable companies in the asset class. As of March 31, 2020, about 27% of companies within the Russell 2000 Index were unprofitable.

Percentage of profitable and unprofitable companies in the russell 2000 index
The Russell 2000 Index is a widely used small cap benchmark. In fact, many exchange-traded funds (ETF’s) and passive mutual funds with a significant amount of assets mirror this market-cap weighted benchmark. Many investors might believe a passive ETF or mutual fund is “safer,” not realizing the high level of exposure to unprofitable companies. A successful active manager will dig deeper to find the most promising small cap stocks with strong business models that exhibit growth, profitability, and free cash flow generation that allows them compound returns over time.  

The Fort Washington Small Company Equity strategy only invests in profitable small cap stocks. This is one of the key tenets of our investment philosophy. Avoiding unprofitable small cap stocks reduces the risk levels of investing in small cap stocks. Furthermore, and most importantly, profitable small cap stocks outperform unprofitable small cap stocks with significantly lower volatility. The chart below illustrates the performance of the profitable and unprofitable constituents of the Russell 2000 Index since July 2001.

Growth of $100 invested in profitable and unprofitable constituents of the russell 2000 index
There are a few reasons why profitable small cap stocks outperform over time. First, they generally do not require access to capital to fund their operations. During an economic downturn or any period where the cost of capital is increasing, unprofitable stocks are at a significant disadvantage. Unprofitable small cap stocks have going-concern or bankruptcy risk in recessions. Another reason is that profitable small cap companies can internally invest in future growth, compounding earnings growth over time, which is ultimately what drives long-term stock returns. Profitability provides flexibility to manage through economic slowdowns and recessions. The chart below illustrates the maximum drawdown risk between profitable and unprofitable stocks in the Russell 2000 Index.

Max drawdown 7/1/2001 - 3/31/2020
Profitable stocks significantly outperform unprofitable stocks in more challenging economic environments, and they also perform very well in robust bull markets. The chart below illustrates the Up Capture Ratio and Down Capture Ratio for profitable and unprofitable small cap stocks over the period. These up and down capture ratios show whether the strategy has outperformed—meaning gained more or lost less than—its benchmark during periods of market strength and weakness, and if so, by how much.

Capture ratios 7/1/2001 - 3/31/2020
When combining the favorable long-term outperformance and lower volatility characteristic of profitable small cap stocks, there is a very favorable reward compared to risk for investing in the profitable spectrum of the U.S. small cap asset class.

Risk versus return analysis 7/1/2001 - 3/31/2020

Bottom Line

Small cap stocks are an inefficient asset class for several reasons – research coverage, liquidity, capacity, and volatility. Due to these inefficiencies and their long-term earnings growth, U.S. small cap stocks have generated very attractive investment returns and outperformed large cap stocks. The key to investing in small cap stocks is to capture the benefits while minimizing the risk. We believe a compelling way to capture those returns while reducing risk is to invest only in profitable small cap stocks. The Small Company Equity strategy at Fort Washington focuses exclusively on profitable small cap stocks.  

About the Author

jason ronovech

Jason Ronovech

Senior Portfolio Manager
Jason is Vice President, Senior Portfolio Manager for the Small Company Equity strategy. He received a BA from Hamilton College and holds the Chartered Financial Analyst (CFA) designation.  
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Discover How Fort Washington Uncovers Inefficiencies in Small Cap Stocks

Explore our previous white paper for a detailed look inside small cap investing. Employing its methodology since 2013 under the leadership of Senior Portfolio Manager Jason Ronovech, CFA, the Fort Washington Small Company Equity strategy has regularly outperformed the Russell 2000 Index with lower downside volatility.

Fort Washington's Approach to Small Cap Investing

Our differentiated approach to investing in Small Cap stocks is designed to capitalize on the inefficiencies of the asset class. Our process utilizes rules-based screens and bottom-up, fundamental research to evaluate companies in the context of four investment cycle stages. Within this framework, we look to identify specific indicators of business model sustainability or degradation.  
IMPORTANT DISCLOSURES
Past performance is not indicative of future results.  This publication contains the current opinions of Fort Washington Investment Advisors, Inc. Such opinions are subject to change without notice. This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Fort Washington or its affiliates may from time to time provide advice with respect to acquiring, holding, or selling a position in the securities mentioned herein. Information and statistics contained herein have been obtained from sources believed to be reliable but are not guaranteed to be accurate or complete. No part of this publication may be reproduced in any form, or referred to in any other publication, without the express written permission of Fort Washington Investment Advisors, Inc.