The Evolution of the Russell 2000® Index and Degradation of Quality in Smaller Market Caps Over the Past Two Decades

While many investors are familiar with the Russell 2000® Index, few may be aware of how the quality profile of the index has gradually degraded since 2001. More specifically, the Russell 2000 has seen a decline in the average quality of its constituents, with an increase in the number of companies with inconsistent profits and speculative business models. Lower quality companies now make up a larger portion of the index compared to historical periods.

 

To gain more insight into this evolution, the Segall Bryant & Hamill Small Cap team analyzed the Russell 2000 Index to identify differences and trends over time in various fundamental factors between the index’s upper half of market capitalization range and its lower half. Exhibit 1 below compares trends in these two market cap ranges based on Return on Invested Capital (ROIC), Free Cash Flow (FCF) Margin, and the percentage of profitable companies. Based on these three metrics, it is clear that:

 

  • Companies in the upper half of the market cap range in the index have displayed greater stability and stronger fundamental characteristics compared to those in the lower half.
  • Companies in the lower half of the market cap range have deteriorated from a quality perspective across all metrics since 2001. 
Factors driving this decline in quality include:
  • The migration of higher ROIC and improving ROIC companies to higher market caps.
  • Higher quality companies remaining in private ownership.
  • Higher quality private and public companies being bought by private equity or strategic buyers.
  • Low interest rates driving less mature companies to enter the public markets earlier.
  • The recent increase in the number of special purpose acquisition companies (SPACs).
Exhibit 1: Bottom Half Market Cap Companies in the Index Have Experienced Broad-Based Quality Deterioration

Source: Russell (benchmark/constituents) and FactSet as of 8/31/23. Each period shown is a 5-year average median number. One cannot invest directly in an index. Indexes are unmanaged and do not incur fees.

Drilling down a bit further in our analysis, we split the bottom half of the Russell 2000 market caps (into the third and fourth quartile of market caps) to further isolate the source of degradation within the index. Based on our results (Exhibit 2), it is clear that the fourth quartile of market cap companies in the Russell 2000 represents a significant drag on overall index quality. ROIC and FCF Margin have both declined over the measurement period and are currently negative or near negative, while only 36% of these companies are profitable (64% unprofitable). 
Exhibit 2: Fourth Quartile Significantly Drags Down the Index Health with Only 36% of Companies Profitable

Source: Russell (benchmark/constituents) and FactSet as of 8/31/23. Each period shown is a 5-year average median number. One cannot invest directly in an index. Indexes are unmanaged and do not incur fees.

The degradation in quality of the Russell 2000 over time, particularly in the smallest market cap quartile, argues for active management in the small cap space now more than ever. SBH’s Small Cap Core and SMID Cap strategies generally focus on building portfolios comprised of both sustainably high ROIC and improving ROIC businesses in addition to companies generating solid or improving free cash flow while also seeking companies that are profitable or near profitability. Combining these attributes with other key pillars of our philosophical approach, such as niche market positioning with defendable competitive advantages, strong management teams, and attractive reward-to-risk ratios has proven advantageous over market cycles.

To learn more about SBH Small Cap Core and SMID Cap Strategies, please reach us at (800) 836-4265 or contactus@sbhic.com.

Published October 2023.

 

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