U.S. Small Caps: Lurking Vulnerabilities

The Federal Reserve (Fed) released its inaugural financial stability report on November 28. In the report, the Fed highlighted two of the main vulnerabilities in the financial system1:

1. Elevated asset valuations

2. Historically high corporate leverage accompanied by a lowering of credit standards

We touched on both risks over the course of this year, in How to Avoid Leverage Risks in Small Caps and How to Manage Valuation Risk in U.S. Equities.

Coming into the year, elevated equity valuations in the U.S. were a major concern. At such high valuations, forward return estimates had become increasingly unattractive.

As a result of the December 2017 corporate tax reform, which bolstered profit growth in 2018, as well as the negative returns for U.S. equities thus far, valuations have become much more modest. This point was also conceded by the Fed in their report.

While there seems to have been improvement on vulnerability number one, the second point has been a vulnerability we have been closely watching, particularly as it relates to small caps.

Zombie Companies

Only time will tell the ultimate impacts of the Fed’s extraordinary easy money policies, which were initiated in the aftermath of the financial crisis. Amid the longest bull market in history, many investors would say the Fed has done an exceptional job.

A legitimate lingering concern, however, is the significant build-up in debt among U.S. corporations. Just as the monetary stimulus was intended to do, corporations have tapped the capital markets for cheap debt financing while rates have been at historically low levels.

Of utmost importance for equity investors is the ability of these corporations to repay their obligations. The increasing attention on identifying firms unable to pay debt servicing costs has resulted in a name for this distained class of profligate companies: zombies.

In the chart below, we plot the percentage of the constituents of the S&P 500 Index and the Russell 2000 Index that are classified as zombie companies. We define zombies as those with current trailing 12-month interest expenses that exceed the average of the past three years of earnings before interest and taxes (EBIT).

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