Small-cap stocks appear to be a bargain, but if you dig a little deeper the story gets more complicated, as detailed in a recent article in the Wall Street Journal.
When it comes to a common benchmark like the Russell 2000, analysts sometimes leave out the companies that aren’t turning a profit, the article reports, and this can have a dramatic effect on how pricey a large portion of the market appears–specifically, leaving out unprofitable companies discounts the market value of the small-cap index by more than a third
This complicated reality gets obscured by simple metrics, the article contends, and investors need to keep that in mind when they divide their money among different areas of the stock market. Analysts are split on which metrics work best. Leaving in unprofitable companies could lead to volatility, which makes it tougher to draw conclusions about how attractive small-cap stocks are.
But the article notes that some analysts say it’s misleading to omit such a substantial share of the Russell 2000—a share which has swelled over the past decade from about 20% to 39%– as it doesn’t provide a realistic view of its price-to-earnings multiple. A trend which, the article notes, is due in large part to the growing presence of biotech stocks.
Investors in biotech are betting that the companies will have breakthroughs in research that will lead to future gains. But as Alex Ely, chief investment officer at Macquarie Asset Management, explains, “If you’re waiting for earnings on a small-cap biotech, you’re not going to own a biotechnology company ever, because they’ll be much larger by the time that comes along.”
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