- Vincent Deluard, a macro strategist at INTL FCStone, says the small-cap stock universe is home to a large number of money-losing companies that are still attracting capital because of some serious investor misconceptions.
- Deluard lays out a series of statistics to show just how absurd he thinks the situation has gotten.
There’s a scam currently unfolding in the stock market — one that’s gone largely unnoticed by investors as they continue unwittingly pouring money into it.
However, if Vincent Deluard has anything to say about the situation, the long-running mirage will soon be exposed.
Deluard — a macro strategist at INTL FCStone — is referring to small-cap stocks, many of which he says are skating by and continuing to attract investment because of some unfortunate investor misunderstandings. At the center of his thesis is the overlooked fact that an inordinate number of small-cap companies are unprofitable — and have been for a long time.
In a new reported titled "A Bull Market For Losers," Deluard points out the following unfortunate realities about the small-cap space:
- More than a third of companies in the Russell 2000 index posted negative earnings last quarter
- Those 671 companies lost a combined $69 billion over the past 12 months, compared to total positive earnings of $33 billion for the entire index
- The market cap of Russell 2000 companies that have negative earnings currently accounts for a record 27% of the overall index (this is shown in the chart below)
Interestingly enough, a lack of profits hasn’t dissuaded investors from piling into the money-losing group, which Deluard has branded a "basket of deplorables." In fact, the cohort has beaten its profitable peers by 19% since January 2016.
Deluard surmises whether it’s a coincidence that this outperformance occurred at a time when the value of bonds with negative yields exploded from near zero to $10 billion over the same period. It likely is not.
That brings us to why Deluard sees small-cap investment as a scam of sorts: the price-to-earnings ratio for the Russell 2000 is currently calculated without including the large share of money-losers. That puts it at roughly 16.5 times earnings.
That’s an appealing number! But wait one second, says Deluard. If you factor in the so-called deplorables, the Russell 2000’s "true P/E" is actually about 75 times. That’s a far less appealing stat. So when investors are buying exchange-traded funds designed to track the Russell 2000, they’re actually gaining exposure to these money-losing companies, perhaps unwittingly.
Let’s just say Deluard is less than inspired by these discoveries.
"If these companies cannot fund their operations when the economy enjoys its longest expansion in recorded history, the unemployment rate sits at a 50-year low, the corporate income tax rate at an 80-year low, and interest rates near a three thousand-year low, how will they ever repay their mounting debt?" Deluard wrote.
An initial reaction one might have when presented with this data is to assume that the deplorable group is simply chock full of biotech companies, which are almost always money-losers until they have a drug breakthrough.
Deluard finds that there are indeed many biotechs involved, but that they’re by no means alone. According to his analysis, a third of the basket comes from companies outside the biotech and software space. They’re "old economy" companies that should theoretically be turning a profit at this point.
But wait, it gets worse.
Deluard has developed a subset of the deplorables group consisting of 408 firms that have lost money in at least 16 of the last 20 quarters. He calls them "serial losers," and their behavior is particularly troublesome.
According to his data, the group has paid about $20 billion in stock-based compensation over the past five years, which is almost equal to the $25 billion in operating losses they incurred over the same span. Not to mention more than half of them bought back their own shares to the tune of $6 billion total.
Deluard says that while this should be problematic for bond investors specifically, they — like their equity counterparts — don’t seem particularly perturbed. As long as they’re not left holding the bag, they don’t care.
"The best they can get is their principal and coupons on time, which currently depend on these companies’ ability to find new investors," Deluard said. "This ponzi-like model does not seem to bother current bond investors."
He continued: "If the bond market does not enforce discipline on cash-burning companies, why should these companies ever turn a profit? It is a bull market for losers."
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