The Quality of New Entrants
New public companies are in large part responsible for the decline in quality in the small-cap index
A few weeks ago we published a piece that explored the declining quality of US small-cap stocks. Our primary observations at the time were that international markets, including Europe and Japan, offered higher quality small-cap stocks at more attractive valuations relative to the US. A consistent question we received from some of our readers was whether the decline in quality has been consistent across all stocks or is attributable to a significant influx of new, unprofitable companies.
We decided to revisit the US small-cap quality question, this time exploring whether the change in quality is attributable to declining profitability of companies that have been public for years, an influx of newly listed unprofitable companies, or de-listings/M&A from highly profitable companies.
Figure 1 below shows an attribution analysis of the impact of changing “core” profitability versus the impact of new entrants and de-listings. We defined “core” companies as anything that had been public for at least three years, “entrants” as companies that have IPOed within the last three years, and “exits” as anything that exited within the last year.
Figure 1: US Small-Cap Median GP/Assets by Cohort (Core, Exits, Entrants)
Source: Capital IQ, Verdad analysis
At a high level, while there has been some decline in core profitability, most of the decrease in quality has come from an influx of unprofitable companies, which, after three years, enter the core cohort and contribute to deteriorating quality. In fact, the companies that have gone public since 2013, net of de-listings, currently account for 57% of our small-cap US universe of 2,750 stocks. Given the steep decline in quality since 2013 among new entrants, this significant influx has contributed to a broad deterioration of quality. To make matters worse, the exits from the small-cap universe have tended to be of higher quality than the core cohort.
Notably, US large caps have not experienced such a significant mix shift toward new, unprofitable companies, and the companies that have entered and exited have tended to be of comparable quality to the broader core cohort. There is also less churn in the large-cap segment: new large-cap companies since 2013, net of de-listings, only account for 15% of our large-cap US universe of 585 stocks.
Figure 2: US Large-Cap Median GP/Assets by Cohort (Core, Exits, Entrants)
Source: Capital IQ, Verdad analysis
Any deterioration in quality among US large caps is primarily attributable to declining “core” quality versus a mix shift toward more unprofitable companies.
Relative to the US, European large- and small-cap stocks have seen comparable trends to US large caps, where entrants and exits are of comparable quality to the existing core, and there has been more stability in core quality.
As we highlighted a few weeks ago, Japanese small caps have shown resilient and even improving quality, which is in part driven by higher-quality entrants, as shown in Figure 3 below.
Figure 3: Japanese Small-Cap Median GP/Assets by Cohort (Core, Exits, Entrants)
Source: Capital IQ, Verdad analysis
Given the low quality of the recent entrants to the US small-cap universe, and the relatively high quality of exits, it’s worth exploring what kinds of companies these are. Since 2013, the distribution of small-cap companies by sector for new entrants and exits is as follows, versus the Russell 2000 and S&P 500 on 12/31/2012.
Figure 4: Sector Distribution of New Entrants and Exits
Source: Capital IQ, Verdad analysis
The new entrants to the US small-cap universe, on a market cap-weighted basis, have been heavily concentrated in biotech, financials, and health care. The SPAC boom of 2021 comprised a large portion of the financial entrants, but the biotech and health care overweights are notable.
We believe discerning among small-cap stocks on the basis of both valuation and quality remains paramount to avoid the large number of unattractive, low-quality constituents that have entered the universe in recent years.