Small Cap Stocks Are Dangerous

The Risk/Reward of the entire Russell 2000 gets our Dangerous Rating. Our recently published Index Benchmark report on the Russell 2000 offers unique insights into the underlying profitability and valuation of all the companies comprised by this index. It also offers benchmarks for (1) investors considering buying ETFs or Index Funds based on the Russell 2000 and for (2) comparing individual stocks to the Russell 2000.

Our analysis of the index is based on the market-weighted aggregation of data from our company models for the 1588 companies we cover in the Russell 2000. Appendix 1 in our report lists all companies included. We offer aggregation reports on the Risk/Reward Ratings for any ETF, mutual fund or custom portfolio. Note that our company models incorporate key data from Financial Footnotes and the MD&A to reverse accounting distortion and provide investors with the true economic earnings of businesses. Because we cannot replicate the holdings of proprietary investment vehicles, we provide benchmarks for their Risk/Reward based on the profitability and valuation of a reasonable proxy for the group of companies they hold.

Below is an overview of the five factors that drive our Overall Risk/Reward Rating of Dangerous for this index.

  1. Quality of Earnings
    • Economic versus reported earnings – Very Dangerous/Misleading Earnings
    • Quintile Ranking for return on invested capital (ROIC) – Dangerous/4th Quintile
  2. Valuation
    • Free Cash Flow Yield – Neutral at 1.5%
    • Price-to-economic book value – Attractive at 1.3
    • Growth Appreciation Period – Very Dangerous at 56 years

Definitions of the five factors that drive our Risk Reward Ratings are below:

  1. Quality of Earnings
  2. Valuation
    • Free Cash Flow Yield –  measures the market-weighted average of the free cash flow divided by enterprise value for the companies we cover in each index
    • Price-to-economic book value –  measures the market-weighted average of stock price divided by the economic book value of the companies we cover in each index
    • Growth Appreciation Period – measures the market-weighted average of the market-implied growth appreciation period for the companies we cover in each index

Note that the individual company models used to perform this analysis incorporate key data from Financial Footnotes and the MD&A to reverse accounting distortion and provide investors with the true economic earnings of businesses.

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