Small Cap Stocks: A Closer Look at the True Opportunity

Small Cap Stocks: A Closer Look at the True Opportunity

Concerns of an impending recession mean it might be time to revisit opportunities in quality value small cap stocks.

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Reviewed by: etf.com Staff
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Edited by: etf.com Staff

2022 brought on the highest inflation in 40 years and the worst calendar year performance for the stock market since 2008. With concerns of an impending recession looming, and a potential 5% Fed funds rate on the horizon, now seems like a good time to revisit the small-cap investing landscape, especially opportunities in quality value small-cap stocks.

Key Takeaways

  • Small-cap stocks are trading at a record discount relative to large-cap companies. However, based on relative free cash flow yield and a P/E multiple that factors in non-earners, small-cap names may be more expensive than they seem.
  • Small-cap companies' leverage issues are still concerning, particularly in a higher fed fund rate period which we are currently in.
  • High free cash flow yielding small-cap stocks demonstrate higher quality and a lower valuation than the broad- based benchmark, offering better potential amid a macro recovery.

From a valuation standpoint, small-caps appear to have already priced in a deep recession. The Russell 2000 Index’s forward P/E (price to earnings) is now in line with the 2008 lows and is lower than the levels reached during the 2001 recession. Relative to the Russell 1000 Index, the Russell 2000 Index’s 11.42 forward P/E is nearing its lowest level since 1999, indicating an almost 40% discount to the large-cap peers.

The Real Value of Small-Caps

Usually, when the P/E multiples are low, we’d expect a relatively high free cash flow yield (free cash flow/enterprise value) number, indicating suppressed market prices. However, that is not currently the case in small-caps.

Unlike large-caps, small-cap companies' free cash flow yield levels are off their 2021 post-COVID high due to weak free cash flow (FCF) generation. Notably, the Russell 2000 Index’s FCF has been trending downward since 2021. There has been a scarcity of FCF in the small-cap world, as demonstrated by the measly 0.06% median FCF margin among companies within the Russell 2000 Index. Meanwhile, the median FCF margin for companies in the Russell 1000 Index

stands at 7.78%. Small-caps currently carry FCF yields well below their large-cap peers, and trade at some of the lowest FCF yield levels in the past 20 years.

Clearly, there is a deterioration in small-cap fundamentals, which justifies their low valuations. But the question is: are small-caps cheap enough to invest in now?

As we highlighted previously, almost half of the companies in the Russell 2000 Index are currently generating negative earnings. Even though, the negative impact of COVID pandemic has faded, 40% of the small- cap universe remains unprofitable.

This highlights one of the limitations of valuation multiples, like the P/E ratios. When the denominator (earnings) is negative, the P/E calculation ceases to be useful. As such, the aforementioned 11.42 forward P/E of the Russell 2000 Index only reflects the valuations of the small-cap names with positive projected earnings.

Suppose we include companies with negative earnings in the P/E calculation. In that case, the Russell 2000 Index is more expensive than the Russell 1000 Index (22 vs. 17.9), which is more in-line with what we’d expect given the corresponding FCF yield levels of the two indices.

So, based on our findings thus far, from a valuation standpoint, small-caps, as an asset class, do not seem sufficiently cheap enough to be an attractive bet for investors.

The Small-Caps Leverage Issues

In addition to concerns surrounding the profitability of small-cap stocks, there are other fundamental features which warrant further caution for investors considering an allocation to small-caps.

Small-cap stocks are traditionally more leveraged than their large-cap counterparts. Particularly in the months following the advent of the COVID-19 pandemic, small-cap’s Net Debt/EBITDA ratios reached the highest level in history.

This trend reversed by the end of 2022, and small-caps’ balance sheets improved as leverage ratios returned to pre- COVID levels . However, the current 3X Net Debt/EBITDA is still higher than the levels following the financial crisis, when interest rates were pushed to almost zero as the result of the Fed’s QE program. Now that the Fed fund rate is trending towards 5% following the most aggressive pace of interest rate hikes in history , it is hard to imagine that such highly leveraged companies will fare well in the current environment.

Additionally, floating rate makes up almost half of small-cap companies’ debts, thus increasing financing costs and negatively impacting small-cap earnings as rates could potentially remain elevated for the foreseeable future.

Is there a better way to invest in small-caps?

We believe high-quality, value-oriented small-cap companies, particularly those with strong free cash flows and healthy balance sheets, are best positioned for the current environment.

The Pacer US Small Cap Cash Cows Index (CALF Index) consists of 100 small-cap stocks with high free cash flow yields. These companies are more profitable and less leveraged than their broad-based small-cap benchmarks.

Companies in the CALF Index not only trade at a significant discount relative to its small-cap benchmarks, but also recently reached the lowest forward P/E since 2017. The record FCF yield premium over the Russell 2000 Index and the S&P 600 Index further confirms the attractive valuation discount of companies in the CALF Index, which could offer great potential for price appreciation in the event of a macroeconomic recovery.

The post-COVID bear market recovery offered a live example: In the 12 months after the market bottomed in March 2020, the CALF Index posted a 158% return, outperforming the Russell 2000 Index and the S&P 600 Index by more than 38%.

The Pacer US Small Cap Cash Cows 100 ETF (CALF) tracks the Pacer US Small Cap Cash Cows Index, investing in the top 100 highest free cash flow yielding companies within the S&P 600 Index. It aims to offer investors a way to gain exposure to high-quality companies with high free cash flow and strong balance sheets. Additionally, CALF’s current relative valuation discount is amongst the steepest in history, which may offer great potential once economic conditions improve.


Russell 1000 Index: The Russell 1000 Index is a stock market index used as a benchmark by investors. It is a subset of the larger Russell 3000 Index and represents the 1000 top companies by market capitalization in the United States.  
Russell 2000 Index: The Russell 2000 Index refers to a stock market index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.  
S&P 600 Index: The S&P 600 is an index of small-cap stocks managed by Standard & Poor's. It tracks a broad range of small-sized companies that meet specific liquidity and stability requirements. This is determined by specific metrics such as public float, market capitalization, and financial viability, among other factors.  
Small-cap: A stock from a public company whose total market value, or market capitalization, is about $300 million to $2 billion. The precise figures vary.  
Large-cap: A company with a market capitalization value of more than $10 billion. The precise figures vary.  
Return on Equity (ROE): The measure of a company's annual return (net income) divided by the value of its total shareholders' equity, expressed as a percentage.  
Net Debt/EBITDA ratio: A measurement of leverage, calculated as a company's interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA.  
EBITDA: Earnings before interest, taxes, depreciation, and amortization; is calculated by adding interest, tax, depreciation, and amortization expenses to net income.  
Free Cash Flow (FCF): A company’s cash flow from operations minus capital expenditures (expenses, interest, taxes, and long-term investments) Free Cash Flow Yield: FCF/EV. Measures a company’s total free cash flow relative to its enterprise value. This is an internal statistic and does not constitute investor yield.  
Free Cash Flow Margin (FCF/Sales): Measures a company's total free cash flow relative to its sales.  
Enterprise Value (EV): A company’s market capitalization adjusted to eliminate any capital structure bias (i.e. by adding debt and subtracting cash or cash equivalents)  
Sales: The value of what a company sold to its customers during a given period; also known as revenue.  
P/E: Price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). Forward P/E: Forward price-to-earnings is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation. Floating Debt: Debt on which the interest rate changes as the existing rate changes.  
Fixed Debt: Debt on which the interest rate is fixed and does not change as the existing rate changes.

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The Pacer US Small Cap Cash Cows Index was released on 5/29/17.  

The Pacer US Small Cap Cash Cows Index (the “Index”) is the property of Index Design Group, LLC which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Index Design Group, LLC. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC  

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