Commentary: One effect of low interest rates? More loss-making U.S. small-caps

Updated with clarification

The coronavirus is dominating headlines and, most likely, will continue to do so for some time to come. The slowdown in economic activity as a result of the government policy response to it has cut a swath through many industries. With COVID-19 still widespread in many developed economies, it is not possible to analyze its effects in full at this point. All this comes on top of the devastating direct effect of the virus on the population in terms of illness and deaths.

However, it is quite possible that it will put pressure on some companies that have benefited from the interlinked combination of low interest rates and investors' search for yield. Turning to what may now seem like older than yesterday's news, up until the end of last year the U.S. was enjoying a lengthy period of economic growth, with the fourth quarter marking the 23rd consecutive quarter of expansion in GDP. Yet, the proportion of U.S. small-cap companies making a loss is well above the lows recorded in some similar periods in the past.

We believe that U.S. small cap continues to be an inefficient and attractive asset class with long-term upside potential, and that investors should consider a defensively positioned portfolio that includes well-researched companies with strong balance sheets, sustainable business models, and strong cash flows to support growth and dividend payments. These companies should provide good upside participation in rising markets, but hold on to value in periods of weakness.

In 2018, the latest year for which full data is available, 32% of companies in the small-cap universe were loss-making — point A on the chart below. But at a similar stage in earlier economic cycles, the percentage was lower: 18% in 1996 (point C), and 24% in 2007 (point B).

This behavior is not attributable to industries often associated with losses, such as biotech and some niche areas of software development. Excluding these, there are still more loss makers than in previous, similar periods.

Further, not only are losses becoming more prevalent, more companies are becoming loss-making over extended periods. Of those companies in the universe that reported a loss in 2018, 19% had made a loss over each of the previous three years. Prior to the great financial crisis, the last time the percentage of loss-making firms in the universe was about 30% and rising was 2001. In that year, only 6% of companies had made a loss over each of the previous three years.

Low interest rates are playing a part: cheap loans and willing lenders allow companies to borrow to stay afloat. Moreover, they allow management to put off difficult decisions about trimming costs. Also, cheap finance allows firms to engage in M&A activity with perhaps less caution than when interest rates were higher. In other words, cheap money leads to misallocation of capital within the economy.

Another issue is that among non-financial names in the universe, debt levels — as measured by net debt to EBITDA — are elevated. Indeed, it is at a similar level now to the peak seen in 2001 during the debt-fueled tech bubble, an event which ended badly for many investors.

The trend rise in loss makers (see chart) has accompanied the trend down in interest rates. This decline in yield makes future growth look more attractive on a discounted cash-flow basis. However, the greater emphasis on distant future profits increases uncertainty, possibly leading to share price volatility.

If, as seems increasingly likely, the current coronavirus shock is the catalyst for a protracted downturn in economies and financial markets, then this combination of losses and indebtedness suggests that careful analysis of companies is appropriate for defensive investors.

Brendan Baker is a senior portfolio manager at Mondrian Investment Partners Ltd., London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.