Why You Shouldn’t Judge Small-Cap Stocks By the Russell 2000

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The Russell 2000 is the Benchmark Index for Small Caps. But the Best Small-Cap Stocks Don’t Always Stay There.

As Chief Analyst of Cabot Small-Cap Confidential you’d think I would spend a lot of time looking at and analyzing the small-cap stock index. But I don’t.

Why?

It starts with performance. Or to be more precise, lack of performance.

This year the Russell 2000 Small Cap Index is down by 14.2%. The S&P 500 is up 1.5%. That’s a 15.7% performance differential.

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Year to date the Russell 2000 has fared much better. It’s up 7.8%, versus a 15% gain in the S&P 500 Index.

But considering the longer time frame, and that the S&P 500 is just falling (sharply) from all-time highs while the Russell 2000 is 17% off its all-time high, it’s clear that small caps, as an asset class, are underperforming.

I find this frustrating because the Russell’s performance implies to the everyday investor that small-cap stocks are not a wise investment.

And at an index level it’s true … small-cap stocks are stuck in the mud.

But nothing could be further from the truth when you look at a narrower subset of small-cap stocks. I’m referring mainly to the three groups of technology, biotech and MedTech stocks that I cover in Cabot Small-Cap Confidential. The performance of these small-cap stocks is off the charts!

Our 15 small-cap stocks are up by an average of 100%. And if you compare the average gain of each of our stocks to the Russell 2000, over the exact same holding period, our stocks are outperforming by an average of 94%.

Bottom line – the average investor who doesn’t look any deeper than small-cap index performance is missing out on all the great small-cap growth stocks of today, which will likely become the mid-cap stocks of tomorrow.

And they don’t need to.

Why the Russell 2000 is Stuck In The Mud

There are a lot of ways we can unpack why small caps are underperforming. But given time and space constraints I’m mostly going to rail against the Russell 2000 Index, which just went through its annual reconstitution in June, in broad generalities.

For those that don’t know, the Russell 2000 is a group of 2,000 small market-cap stocks that FTSE Russell decides are most relevant each year.

Their pitch is that this market cap constrained methodology removes subjectivity and increases transparency, so index investors get an index that’s “representative, reliable and relevant.”

There are three current underlying issues with the Russell 2000 Small Cap Index that I see.

First, there’s no real type of quality screen. Sure, removing subjectivity from index stock selection is great, if the subjective opinions of decision makers is dreadful.

But if subjective opinions are good, that’s what you want! The Russell 2000 doesn’t allow for good, subjective stock additions and deletions.

Second, there’s the upward migration issue. Growth investors know that good stocks go up! If all the good small-cap companies are getting bigger where’s the incentive to blindly purchase a basket of 2000 smaller companies? Especially when upward migration – which happens when companies that get too big for the Russell 2000 are removed from the index – takes away all the best-performing companies?

It would be one thing if the IPO market refreshed the index at the low end with a constant stream of new blood. But from what I’ve seen IPOs are getting bigger, not smaller.

While there are a lot of good companies that enter the small-cap index each year, they are dwarfed by the sheer number of stocks that don’t perform well.

The S&P 500 doesn’t suffer from this upward migration issue. A great growth stock can keep going up, and that performance won’t lead to its eventual removal from the index.

And third, the world, and the stock market, is changing. The emergence of new technologies, like cloud computing, are driving massive changes. One of those changes is that the strong are getting stronger as these businesses scale up more rapidly than businesses of yesteryear.

Much of that performance is being captured in the S&P 500. In that index, Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Facebook (FB) and Alphabet (GOOG) have a combined weighting of almost 16%.

That’s huge. And remember, NONE of these stocks will migrate up and out of the S&P 500. Not even Microsoft, which currently has a market cap over $1 trillion! This is part of why technology makes up over 20% of the S&P 500 Index.

In contrast, technology only holds a 12% allocation in the Russell 2000 Index. And of the top 10 positions, only one of them is a technology stock. It’s Science Applications International (SAIC). And it has a weighting of 0.25%.

Think about that. The S&P 500 holds five of the most successful technology companies in history, with a 16% weighting. And they don’t need to leave the index. Ever.

In comparison, the Russell 2000 holds one tech stock in its top 10 positions, with a measly 0.25% weighting. If and when it gets too big, it will leave the index.

How can the Russell 2000 ever compete?

There are a lot of other nuances we could talk about when comparing relative attributes and performance of the Russell 2000 and S&P 500. But is it worth the time and effort?

I don’t think so. Which is why I find myself spending less and less time looking at the small-cap index, and its performance. Unless it’s to bash it.

As currently constituted, the Russell 2000 Index holds zero allure for growth investors, in my humble opinion.

This Is Where Investors Should Look for Big Opportunities

My main job as a chief analyst of Cabot Small-Cap Confidential is to pick small-cap stocks that go up.

And as I mentioned above, my method has been working. My 15 Cabot Small-Cap Confidential stocks are up an average of 100%, and their average performance is beating their benchmark Russell 2000 Index by an almost unfathomable 94%.

Part of this is due to good stock picking, part to luck, and, I’ll be the first to admit, partly because the Russell 2000 makes for a very easy-to-beat benchmark.

I’d love to have you as a subscriber. If you’re interested, just click here.

And if you’re not, consider other ways to gain exposure to high growth and strong performing small-cap stocks without going to the Russell 2000.

A couple places to start are with mutual funds from Conestoga, Fidelity and Brown. All have fund options that are much more concentrated than the Russell 2000 and will give you exposure to more of what’s working, and less of what isn’t.

After all, isn’t that the whole point?

Tyler Laundon

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Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!

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