Small and medium-sized US companies suffered a complete wipeout in profits in the second quarter because of the Covid-19 crisis, in sharp contrast to large multinationals that emerged from the most intense phase of the pandemic in better shape.
As the earnings season draws to a close, companies within the Russell 2000 stock index — the small-cap benchmark — have reported an aggregate loss of $1.1bn, compared to profits of almost $18bn a year earlier, according to data provider FactSet. Meantime, the much bigger companies within the benchmark S&P 500 index have posted a 34 per cent aggregate drop in earnings, to $233bn.
Investors said the figures underline a divide between the small companies that have been squeezed by the Covid-induced recession and the bigger companies that “have the strength to ride out whatever is thrown at them,” said Margie Patel, a senior portfolio manager at Wells Fargo Asset Management.
“Small companies don’t have the resources,” she added. “They don’t have the deep financial pockets.”
The gap is reflected in the returns of the two major indices. The S&P 500 — which dropped more than 30 per cent in the Covid-19 sell-off — is now 3.2 per cent above where it began the year. The Russell 2000, by contrast, is still 5.6 per cent lower year-to-date.
This divergence reflects the market’s “apprehension” that smaller companies may struggle to stay in business, said Ralph Bassett, head of North American equities at Aberdeen Standard Investments.
Lockdowns and social-distancing measures aimed at curbing the spread of the deadly coronavirus pandemic pushed the US into its biggest postwar contraction between April and June. Bankruptcy filings have soared and more than 16m Americans remain on unemployment benefits, with many job losses becoming permanent.
“The shock to economic growth has had a particularly pronounced impact on small firms,” said David Kostin, a strategist with Goldman Sachs. Stronger balance sheets and higher profit margins helped “insulate” larger companies’ profits, he added.
While bigger groups were able to quickly raise needed cash starting in mid-March, smaller companies struggled to tide themselves over. Many turned to government programmes. However, with stimulus measures now lapsing, many small companies once again find themselves in need of capital.
“Small-cap companies don’t have as much cash sitting around and they don’t have the flexibility to reduce costs as much, especially during the time when there was no revenue coming in,” said Liz Young, the director of market strategy at BNY Mellon Investment Management. “They are the companies that will need help in this crisis.”
Smaller groups operated with “razor-thin profit margins” even before the pandemic, according to Craig Burelle, an analyst at asset manager Loomis Sayles. About a third of the groups within the Russell 2000 did not turn a profit before the crisis hit this year, and the index itself was “highly exposed to cyclical sectors which tend to experience the most fundamental deterioration in an economic downturn”, he said.
The small-cap benchmark is weighted heavily towards healthcare — including lossmaking biotech groups — as well as financials, apparel companies and industrials. Goodyear Tire & Rubber of Akron, Ohio, one of the bigger constituents, was a good example of a company hit hard, reporting a 41 per cent collapse in sales and a quarterly loss of $696m, from a profit of $54m a year earlier.
The difference in fortunes is partly explained by the smaller proportion of tech businesses in the small-cap index. While technology stocks now account for about 27 per cent of the S&P 500, they make up just under 14 per cent of the groups within the Russell 2000.
The earnings generated by Apple, Microsoft, Amazon, Alphabet and Facebook — the five mega-cap tech companies that dominate the blue-chip benchmark — increased 2 per cent collectively in the quarter, according to Goldman Sachs. Amazon notched a 40 per cent rise in revenues as locked-down consumers turned to the company for groceries and other products.
Analysts’ forecasts remain downbeat for the remainder of the year, though they are beginning to drift higher. FactSet now expects earnings for the S&P 500 to be down 23 per cent year-on-year in the third quarter, from a previous estimate of a 26 per cent decline.
But investors’ confidence in another round of fiscal stimulus, which has been critical in supporting consumer spending through the crisis, has faltered as Republicans and Democrats remain at odds over what should be in the package. This is making strategists uneasy about whether the broad-based resurgence in US stocks — the S&P 500 came very close to its all-time high — can be maintained.
“It seems that the massive policy response, both fiscal and monetary, has mattered more to the market than the trajectory of earnings growth,” said David Kelly, the chief global market strategist of JPMorgan Asset Management. “However, over the long run stocks tend to follow earnings and . . . at some point these lofty valuations will need to be reconciled.”