Small-Caps’ Big Debt Problem Expected to Get Even More Expensive

Small-cap stocks, while seemingly cheap compared to their expensive large-cap counterparts, are strangled with a big debt problem that could get even worse. The core of the issue lies in how smaller companies fund themselves amid a sharp rise in interest rates.

The historic pace of rate increase, and the realization that rates aren’t likely to head down as soon as originally thought, is a big problem. This is because increased debt service costs become an anchor on growth and earnings. While investors have been waiting for small-cap stocks to reclaim their position as top performers for years, current conditions suggest that rushing in without being selective could be a mistake.

Debt Time Bomb

One key factor hindering an extended small-cap rally is the sector’s high debt burden, particularly the reliance on floating-rate debt. Data from Bloomberg shows that a staggering $832 billion in borrowings hangs over the Russell 2000 (RUT), with a sizeable 75% ($620 billion) needing refinancing by 2029. This compares poorly to the S&P 500 (SPX), where only half of the underlying companies’ obligations mature in that timeframe.

The difference in debt structure between large-cap and small-cap companies is crucial. Small companies lack the size to access the bond market and typically rely on floating-rate loans. This means that their interest expenses rise or fall in sync with the Federal Reserve’s rate moves. As rates have risen and remained elevated, their profit margins have been squeezed much faster than those of large companies that have longer-term fixed-rate bonds.

Marija Veitmane, senior multi-asset strategist at State Street Global Markets (NYSE:STT), discussed why her firm is negative on the sector. Veitmane stated, “Small caps are much more sensitive to an economic slowdown,” noting that their higher cost of funding is “likely to be squeezed more.”

Small Caps Vulnerable in Downturn

Beyond the debt challenge, companies with a smaller market cap are inherently more susceptible to economic fluctuations. Their performance is often tightly linked to the overall health of the economy. With recent crosscurrents in the economy offering only uncertainty, especially inflation proving to be more persistent than anticipated, investors are wary of embracing “riskier” assets like small-caps. The attractive valuations are not nearly attractive enough.

This cautious sentiment is reflected in the lackluster performance of the Russell 2000. While the S&P 500 has gained a respectable 9.5% year-to-date, the Russell 2000 lags behind with a paltry 1.6% return. This lagging trend extends even further back, with the S&P 500 more than doubling the Russell 2000’s performance since the beginning of 2023.

Guy Miller, chief market strategist at Zurich Insurance Co., shares his thoughts on why the bigger names are more expensive: “they tend not to have any issues around funding and are less dependent on interest rate policy.”

Selection Is Imperative

While the overall picture for small caps seems daunting, some analysts believe there might still be diamonds in the rough. David Lefkowitz, head of US equities at UBS Global Wealth Management (NYSE:UBS), sees potential support for the sector if interest rates fall by year-end, coupled with an uptick in business activity leading to stronger earnings.

Bank of America (NYSE:BAC) strategist Jill Carey Hall also sees opportunities within specific sectors. She recommends being “selective” and focusing on pockets in energy, materials, and industrials. These are areas that benefit from an improving economy and have a lower refinancing risk.

Key Takeaway

Investors remain cautious, waiting for clearer signs of slowing inflation and a potential Fed pivot towards rate cuts before diving into small caps. The dominance of large-cap technology giants, offering relative safety during uncertain times, further dampens enthusiasm for small-caps for now. However, for selective investors who wish to navigate the debt and economic headwinds, they should consider exploring analysts’ perspectives on TipRanks for specific opportunities that may be hidden within the small-cap universe.